So what is the Fiscal Cliff all about? Well, the "scare" version of the story is that on January 1, 2013 all kinds of bad things will immediately happen causing the economy to crash causing the immediate end of all we hold dear. As you might imagine this is not an accurate characterization of the situation. A more accurate characterization of the situation is that if no laws are changed between now and January 1 then federal taxes will go up somewhat and federal spending will go down somewhat. So why is this the end of life as we know it? Because the CBO (Congressional Budget Office) estimate is that this will stall the current anemic rate growth that the U.S. economy is now experiencing and throw us into a very mild recession. Do we know for sure this is going to happen? No! It's just a best guess by a usually reliable source.
So, assuming politics in our nation's capital continues to gridlock, what actually happens? Several things:
- The Bush tax cuts expire. This will cause tax rates to be raised on pretty much everybody. If you currently pay income taxes, those taxes will likely be higher.
- The Obama Social Security withholding rates go back up to the rates they were a few years ago. This means that an additional two percent of most people's salary will be withheld.
- The "sequester" will kick in. The Defense Department budget will be cut by $55 billion per year. Funding for "non-defense discretionary spending" will be cut by $55 billion per year. These are characterized as "draconian" by the people who passed the bill that causes these cuts.
Finally, there is a theoretically unrelated event that will affect the federal budget that will happen at roughly the same time and often gets lumped in with everything else. The U.S. has a "debt ceiling" law. The federal debt is only allowed to raise to a certain level. We are near that level. There are various tricks and gimmicks that can be used to keep things going once the limit is reached. But this trickery will only work for a short period of time, a few months. The best current estimate is that the debt ceiling needs to be raised by February 2013. There was a big fight the last time the debt ceiling needed to be raised. There is no reason to think that this time around will be any different. Many people have suggested that a debt ceiling increase be rolled into the same legislative package that would address the fiscal cliff.
So how did we get here? It actually goes back to the early part of the Bush '43 Administration. They wanted to do a big tax cut. But whenever a tax cut is under serious consideration the CBO does an analysis of the impact over a 20 year time horizon. Had the CBO done this the number would have been truly scary and it would have been harder for the bill to pass. So the Bush tax cut was made "temporary". It would expire in 2010. Since taxes and, therefore, revenues would revert to the old amounts, the cost of the tax cut was way less scary and the bill was passed and was signed into law. This worked so well that the Bush Administration pulled the same trick with s second tax cut they put through a couple of years later. They also made it expire in 2010. Now notice that 2010 is after the end of a two term Bush Administration. It becomes someone else's problem. And the cynical calculation was that the tax cut would never actually get repealed so the Administration got to have their cake and eat it too. So far the prediction is working out. A deal was done in the 2010 "lame duck" session to extend all provisions of both tax cuts for two more years. So now they expire at the end of 2012.
When the Obama Administration came in they were faced with an economy that was truly a disaster. Their first response was to pass a "stimulus" bill. One of the provisions of this bill was a "temporary" reduction in Social Security withholding. Normally 6.2% of an employee's salary is withheld for Social Security. This is matched by the employer, except that self employed people have to pay the "employer" part too. The "stim" reduced the employee amount to 4.2%. This saved an individual making $50,000 per year $1,000. As part of the deal that was made in the 2010 lame duck this provision was extended for 2 years so it expires in 2012 now too.
As a result of a political deal made a couple of years ago a "super committee" consisting of equal numbers of Democrats and Republicans and equal numbers of Senators and Representatives was formed. To encourage them to come to a bipartisan deficit reduction deal a provision in the enabling legislation was included that said if they failed then starting in 2013 "draconian" (that was the design objective) cuts would be automatically mandated. To spur on Republicans one of the cuts was $55 billion per year to the Defense budget. To spur on Democrats the other cut was $55 Billion per year to "non-defense discretionary" programs. What is in and out of this latter category is spelled out but it is complicated. It's things like the NASA, Education, etc. Social Security and Medicare were specifically exempted. Needless to say, the super committee failed so the cuts are scheduled to go into effect if something is not done right away.
I have left out a lot of detail and I'm sure I have put most of you to sleep anyhow. So let's just move on to what should be done. We are now living in a political world at the federal level where everything is pushed to the limit so what should be minor or routine actions are blocked or delayed to the last minute and beyond. If we had a functioning political system many of the components of the fiscal cliff would have long since been taken care of. I lay almost 100% of the blame for this brinkmanship on the doorstep of the Republicans.
As a simple example, they forced a confrontation the last time the debt ceiling need to be raised. This has historically been a routine activity. There is usually some posturing but neither side does anything to stop the ceiling from being raised in a timely and predictable manner. The last time around the Republicans brought the entire country to within hours of a total default of the government. And that was after the Treasury pulled every trick and gimmick that anyone could think of to stave off what would normally have been the default date. I could cite several other examples of Republican brinkmanship. But if you don't want to agree with my characterization of the "debt debacle" then you aren't going to buy my analysis of the other events. And, if you agree with my "debt debacle" analysis, then you can take my word for it that the other events are there and happened too.
So it is important to recognize that we have not only a "fiscal cliff" problem but we also have a Republican intransigence problem. If we don't do something about both of them we don't make any real progress. So what should be done?
Option 1 is to do what the Republicans say they want. That would be to continue all the tax cuts (the Bush tax cuts, the Obama tax cuts, and the other tax provisions I haven't gone into). They would also repeal and replace the "sequester". They would make no cuts to the Defense budget. Instead they would make very large cuts to "non-defense discretionary" and additional cuts to Social Security, Medicare, and Medicaid. That is what they would do as best I can make it out. They have not been very specific.
Option 2 is to do what President Obama wants to do. He too has been pretty vague. He would increase taxes on people making more than $250,000 per year. He would preserve all the tax cuts for people making less. As far as I can tell, he would leave the sequester in place. This is good as far as it goes. I am all in favor of the increase in taxes on rich people. The problem is that it does not raise enough money. I think we should raise taxes on the wealthy anyhow on fairness grounds.
Option 3 is to go off the cliff. Let everything expire or go into effect.
Before continuing, let me state the obvious. All of these pure positions are seriously flawed. It is a bad idea to do any of them in their purest simplest form. But they give us a starting point for discussion. So let's discuss.
Option 1 is the most ridiculous. The oratorical way the Republicans square the circle on this proposal is they offer to close loopholes in the tax code. I am all in favor of this as a general principle but the devil is in the details. And so far the Republicans have provided no details. Well that's not completely true. One Republican or another has taken pretty much all the big loopholes off the table. My idea of "low hanging fruit" is various loopholes that favor the Oil industry. Democrats have put together bills that close one or more of these loopholes. None of these efforts has garnered a single Republican vote. Two big loopholes that affect individuals are deductions for education expenses and mortgage expenses. Various Republicans have taken both of these off the table. There is the "carried interest" loophole. This allows Hedge Fund managers to treat their multimillion dollar bonuses as Capital Gaines taxed at 15% rather than as ordinary income taxed at 35%. Republicans have shot down the idea of closing the carried interest loophole.
In fact, you can find various Republicans taking all the big loopholes, corporate and individual, off the table at one time or other. And no Republican has publicly supported eliminating a single specific loophole. I am absolutely convinced that had Mitt Romney won the election and succeeded in getting his tax and budget programs enacted into law then no loopholes would have been closed, defense spending would have gone up, tax rates might have been cut, discretionary spending and entitlements would have been cut, and the deficit would have grown enormously. That's what history says Republicans do when they get into the White House.
Option 2 is better but not by a lot. The President has been short on detail in public. As I have indicated above, raising rates on high income people is a good idea but it only solves a small part of the problem. Apparently the President tentatively agreed to a package that included entitlement cuts (styled as "reforms") and cuts to discretionary programs. But we don't know the details. If the Republicans actually came up with some loopholes to close, and they were reasonable loopholes, I'm sure the President would go along with them. Besides the ones listed above, there is another loophole I would like to see closed. I would like for mortgage interest to be only deductible on a singe primary residence, as in you would have to live in the house for it to be deductible. This would not bring in a lot of money but I still think its a good idea.
Now lets talk about options 3. Actually, I want to talk about two variants. Option 3a is the "limited" version. We let everything go into effect. That defines a new base case. Then, after the new congress goes into session in early January, we enact legislation reversing or modifying the components we don't like. This is the version advocated by Lawrence O'Donnell of MSNBC, for instance. Why would we want to do this? In a word (actually two) Grover Norquist. Norquist put together a "no tax increases, ever" pledge and got almost all Republicans to sign it. Increasing the tax rate on rich people counts as a violation of the pledge and would result in bad things happening to the Republican in question, if the past is any guide. Enacting tax increases on rich people (i.e. the Obama plan) violates the pledge if it is done before January 1. But after January 1 all those higher rates have already gone into effect. So leaving the rate high on rich people is not a violation of the pledge. And cutting the rates on non-rich people is fine and dandy. Finally, if the new laws are passed and put into effect in the first month or two of 2013 the damage to the economy is tiny. And many provisions can be made retroactive to January 1, causing even less harm to the economy.
The other version, option 3b, is to let the various provisions expire or go into effect and then do nothing. This is supposed to be very bad for the economy. But it might not be. I cite the example of the first couple of years of the Reagan Administration. Reagan fired the Air Traffic Controllers in a labor dispute. The Fed drove up interest rates. These, combined with some other actions, drove the economy into recession. But it was a short sharp recession. The economic problem at the time was a wage/price spiral that resulted in high inflation. The recession cured the inflation and within two years the economy started growing robustly.
The Republican view is that the economy is doing poorly for two reasons. First, the deficit is too high. Second, there is a lot of economic uncertainty. Option 3b attacks both of these issues. It would cut the deficit by more than in half in the short run and put us on track toward a balanced budget in the long run. That's what the Republicans say they want. Since this plan requires no new legislation is it definitely feasible in this "gridlock" political environment. So uncertainty is removed. People may be unhappy with the higher taxes but they know what the future looks like and can plan accordingly.
Large U.S. corporations are literally sitting on more than a Trillion dollars of cash. If, due to the certainty of the budget and tax situation, they start spending this pile of cash then the economy could take off and quickly. The CBO analysis of this option assumes there will be no change in corporate behavior and that individuals will cut back on their spending because they will have less disposable income. But if the economy picks up due to higher corporate investment then this will put money directly into the pockets of people hired by these corporations. Their income will go up so their spending will go up. If the economy picks up in general then the income of the employees that are not directly involved in this increased corporate spending may well see their income go up more than enough to compensate for their higher tax load. So we could easily see spending rise rather than dip and the economy growing rather than shrinking.
So option 3b may not be as bad as the CBO estimates. But let's say the CBO is right. Everyone will adjust. So I predict a short mild recession. After we exit from the recession we have a federal government that is on a sound and sustainable course. So growth should be robust and sustained. So even the bad version of options 3b is not so bad.
I find it very unlikely that either options 1 or 2 will happen. It is possible that some blend of options 1 and 2 will come out of a genuine effort by the Republicans to compromise. But it is very hard to imagine such a deal coming together quickly enough to be implemented before the end of the year. So I see option 3 as what we will see. And I don't see it as all that scary an option. So what will we actually see, option 3a or option 3b? I actually favor some version that is much closer to 3b than 3a. I have skipped over a bunch of details when outlining the situation. And, while I am comfortable about all of the major provisions that I outlined above, there are several minor provisions that I think need addressing.
One is the AMT, Alternative Minimum Tax. This was a good idea when it was first enacted. It was designed to close some loopholes used only by the rich. But the provisions were not indexed. As inflation has worked its magic more and more middle class people, people not intended as targets of the AMT provisions are effected. Congress had dealt with this by enacting a series of annual AMT "patch" laws. But the AMT needs to be fixed or repealed. The problem is a political one. A permanent AMT fix is scored by the CBO as a big tax cut as the CBO is forced every year to assume AMT is part of the baseline and, since it hits a lot of people, it theoretically raises a lot of revenue. So the political problem is getting beat up about the high theoretical cost of fixing it.
Another problem is the "doc fix" to Medicare. A few years ago it became obvious that doctors wouldn't take Medicare patients because the compensation rate was too low. So the rate was raised, again temporarily, by 27%. It needs to be permanently raised. Again, on one has wanted to take the political hit for "blowing up the medicare budget" that a permanent fix would entail.
I have mentioned the debt limit above. It needs to be raised.
The implementation of the "sequester" is a robotic "cut everything by the same amount". I think it would be healthy to cut the Defense budget by $55 Billion a year. But I would like a more intelligent approach to how the money is cut. Barney Frank has suggested we can scale back our overseas commitments, especially troops in Europe and Japan, by a lot safely. I agree. This also cuts the money shipped over seas, where it doesn't help our domestic economy much. There are weapons systems (e.g. tanks) that can be cut and bases that can be closed. The money is there.
I am less happy about the "non-defense discretionary" cuts. But if they are the price for the rest of the package I can live with them. But again the "cut everything by the same amount" rule needs to be replaced with cuts that total to the same amount but are applied more intelligently. Personally, I would like to take a big whack out of farm subsidies. Almost all of the money goes to large corporate farms. And, at the other end, I see no reason to subsidize small hobby farms. Most farms that are small enough to look like a traditional family farm are actually hobby farms. The group in the middle, relatively small farms that do support the rural lifestyle, are too hard a target to hit. And a lot of them are already in some commodity that is not part of the farm subsidy program. The only parts of the system that look like they might be a good investment to me are the extension service and research programs at "ag" colleges. I don't know where the Department of Homeland Security fits in all this. But I think there is more "waste, fraud, and inefficiency" in this department than in the Department of Defense, normally the "waste, fraud, and inefficiency" poster child. I think a big whack can be taken out of the Homeland Security budget and, if done intelligently, would result in an increase in the security of the homeland.
There are numerous fixes that should be made to other items affected by the fiscal cliff. But you have to ask yourself: Are these fixes more or less likely to happen if we avoid going off the cliff? I find it extremely hard to believe that they will be approached in an intelligent way if some grand bargain is made and going off the cliff is avoided.
So let's all go off the cliff. It should be a hell of a ride.
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