Deficit Reduction the Hard Way

The confluence of fiscal events scheduled for the end of 2012 represents both a major opportunity and an enormous risk.   Taken together, the restoration of taxes and large spending cuts would reduce ten-year deficits by about $7 trillion and place the budget on a sustainable course.  On the other hand, the Congressional Budget Office estimates that, in the short term, these scheduled events would reduce GDP growth by about 2 percent and increase the unemployment rate by about 1 percentage point, potentially throwing the economy back into recession.  The question is how to deal with this conundrum when members of Congress cannot agree on the day of the week.  The answer may be not to lump all the events together because different components could benefit from different approaches.

The array of things that, in the absence of Congressional action, will happen in December 2012 is astounding:

• The 2001/2003/2010 tax cuts will expire.
• The 2-percent payroll tax holiday will expire.
• Patches to the Alternative Minimum Tax to keep pace with inflation will end.
• Cuts in Medicare payments to physicians, which Congress has deferred since the early 2000s, would take effect.
• An across-the board $1.2 trillion spending sequestration of 10 years would go into effect (as a result of the failure of the Super Committee to reach an agreement).

Federal Reserve Chairman Bernanke refers to this array of looming tax increases and spending cuts as a “fiscal cliff.”  Going off the fiscal cliff would not only harm the economy, but would also represent bad policy.  For example, while more taxes are needed for a balanced approach to reducing deficits, all observers agree that tax reform is needed to rationalize the tax code.  And while spending cuts are inevitable, an across-the-board cut in discretionary programs and defense also does not make sense.

Here’s my recommendation for each component.

The 2001/2003/2010 tax cuts need to expire.  The argument that the cuts should expire only for those with household income above $250,000 is not realistic.   The 2 percent of high-income households cannot solve the nation’s deficit problems alone.  Everybody needs to participate.  If the economy is too weak to raise taxes in December, link the expiration of the cuts to an unemployment trigger.  That is, half the cuts would be eliminated once the unemployment rate hits 7.5 percent, another quarter at 6.5 percent, and the remaining quarter at 5.5 percent.  The tax system does need reforming, but it is easier to do when reform offers the possibility of tax reduction and that possibility is more likely with the Bush tax cuts gone.

The payroll tax cuts need to expire.  Reducing the employee’s tax by 2 percentage points was never a particularly effective stimulus measure and its continuation undermines the financing principle of Social Security.  It will be easier to solve Social Security’s manageable 75-year deficit if the payroll tax revenues are back in place.

The fixes to the Alternative Minimum Tax should be retained.  If a new patch is not enacted retroactively in 2012, millions of people will be subject to a tax that was never designed for them.

Medicare requires a series of coherent proposals, not a sudden 30-percent cut in physician payments, so the “doc fix” should continue.

The sequestration of $1.2 trillion should be enforced, but not applied across the board.  Rather Congress should broaden the categories for cuts to include the entire budget and then select judiciously.  Again, the pattern of those cuts could be linked to the performance of the economy. In short, the fiscal cliff needs to be turned into a gradual descent.  In this environment where raising taxes is virtually impossible, policymakers concerned about long-run deficit reduction cannot pass up the only opportunity available.  That is, the tax cuts must be allowed to expire.  The revenues are desperately needed, additional revenues will facilitate reform, and Social Security needs its money back.  Similarly, slated cuts on the spending side should be honored but done in a more intelligent way.  But neither the tax increases nor the spending cuts all need to occur in December 2012.  They can be triggered by improvements in the economy