Between a Fiscal Rock and a Hard Place

By :: August 19th, 2010

The Congressional Budget Office’s annual mid-session update provides some striking evidence of just how challenging today’s fiscal environment is. Because deficits were so high going into the economic slump, and because the financial crash was so steep, Washington must now navigate between two unacceptable outcomes: tight fiscal policy and slower growth now, or bigger deficits and slower growth later. 

CBO’s latest estimates, summarized nicely in this blog by director Doug Elmendorf, paint the choices in stark terms. On one hand, if we let all the Bush tax cuts expire, allow stimulus to come to an end, and permit domestic spending to grow only fast enough to keep up with inflation, we can bring the federal deficit down to 4.2 percent of Gross Domestic Product in 2012, less than half of this year’s 9.1 percent. Once the economy recovers, deficits would settle in at manageable levels of between 2.5 percent and 3 percent from 2014 to 2020. This scenario, which effectively extends current law, sounds pretty good if the deficit is your biggest worry.

But CBO figures that if we follow that path, the economy would grow by an anemic 2 percent over the next year, and it would be 2014 before the unemployment rate falls to 5 percent from today 9.7 percent. Not so good if your chief concern is fixing the short-run  economy.

At the other extreme, we could extend the Bush tax cuts, continue to exempt millions of Americans from the Alternative Minimum Tax, and maintain government spending at relatively high levels. These policies would add between 0.6 percent and 1.7 percent to growth, relative to the tighter fiscal path. As a result, unemployment 15 months from now would be as much as 0.8 percent lower.

The downside, however, is the deficit in 2020 would reach 8 percent of GDP, nearly twice what it would be if the tax cuts disappear and we limit spending. And over the long run, these higher deficits would take a severe toll on the economy.

CBO’s forecast is just that, and both the economy and the deficit are likely to grow at a somewhat different rate than it projects. But the broad story it tells is pretty accurate. So what to do?

The solution, duh, is to chart a middle course. For instance, Washington could continue a relatively generous fiscal policy for the next year or two--until financial markets, housing, business investment, and employment get back on their feet. But at the same time, it could start phasing down government spending and increasing tax revenues, with an eye towards reaching something resembling fiscal balance in the second half of this decade. It can begin doing that now.

It is easy to imagine what this middle ground looks like: Congress could extend some of the Bush tax cuts for only a year or two and use that time to begin the work of restructuring the tax code, key to creating a revenue system that can support the government we seem to want. At the same time, it could adopt steps to gradually control long-term spending. The harder part is imaging the political will that will get us there.  




  1. Anonymous  ::  8:11 pm on August 19th, 2010:

    I am beginning to believe that as long as a bond market crisis is inevitable, the pain will be less if the crisis occurs sooner rather than later. I don't favor any actions that delay the crisis without addressing the root of the problem. That root is promises that cannot be kept, not even approximately: Medicare, Medicaid, Social Security, and now health care for all. As long as loudly breaking those promises is the first step, I'm ready to support almost any version of reform. Until then, I oppose even debating the issue of whether to change taxes 2% here or there. That's somewhere between pointless and counterproductive.

  2. Anonymous  ::  9:20 pm on August 19th, 2010:

    The requirement that health care be funded into the future, rather than allowing payroll taxes to increase when needed, is the root of the perceived problem. If a trust fund is built up for future Medicare, it will require either borrowing (unacceptable) or an increase to the income tax, likely on the wealthy, when Medicare draws from the fund.
    What can be now is shifting Medicare and Medicaid funding entirely to the states and entirely to an expanded business income tax, with health care tax expenditures taken against this tax (so the rate should be high enough for the offset, which also provides a mandate for purchasing health insurance). If (maybe when) private insurance fails, the BIT can be increased to fully fund single-payer insurance.
    Social Security is a problem in the long term because of demographics, and the way to fix that is to make the Child Tax Credit more generous (and eliminating the tax deductions for state income and property taxes and mortgage interest) and taking the Credit against the expanded business income tax as well (the credit should be available to all workers and TANF recipients and should replace food stamps and housing assistance for non-seniors). The BIT should be high enough to require a wage penalty for childless families.
    In the medium term, the problem for Social Security is its claims against the trust fund. We should not borrow to pay those – rather income tax rates on the top 3 or 4 tax brackets should be increased – with an additional higher bracket created for income over $500,000.
    The first step in raising tax rates to fund the trust fund, however, is to let tax rates on the wealthy go up now.

  3. Anonymous  ::  9:28 pm on August 19th, 2010:

    The White House has a different middle ground, which amounts to letting tax rates on the wealthy go up now and letting the Fiscal Commission come up with medium and long term solutions. Failing that, they will have to come up with a strategy, although I am sure it will be similar to any position supported by the Democratic members of the Commission. I expect something similar to a VAT, although it won't be called one. Both I and Michael Graetz have proposals in this area, although mine has a 2 tiered VAT structure, a more graduated high income surtax and a much more generous subsidy for families.
    Democrats may not support what Michael Graetz or I offer, however the jury is not yet out as to the survival of the Republican Party. A new more socially centrist, fiscally conservative party may be on the horizon – possibly a fusion between the old Reform Party types, the non-GOP faction of the Tea Party movement and the coalition that tried to draft Mayor Bloomberg in 2008. The prevention of such a coalition is likely the reason the Tea Party Express is running wingnut candidates like Sharon Angle – in order to discredit the movement and kill it as quickly as possible. This is a dangerous plan that will likely backfire on them, leading to the party I describe, which will be drawn to something like a VAT or Fair Tax (although not as a single tax).

  4. Anonymous  ::  7:56 pm on August 20th, 2010:

    there is every danger that economy may see the double dip and people will have to bear the heat of the global recession for more years now. all we can do is, not read these finance magazines and be optimistic.

  5. Anonymous  ::  10:32 pm on August 20th, 2010:

    As an economist, I know that tax cuts strain the economy in the long run. However, they take place prior to elections because presidents want to get reelected..and they want to be favored over the other candidate. Its clear now that cutting taxes in the wake of a war is insane in itself. Nonetheless it took place. Good blog, keep it up.