Turning the fiscal cliff into a good thing

The dreaded 'fiscal cliff' can work – if lawmakers strive to achieve the same amount of deficit reduction over a 10-year budget window as is implied by the current-law baseline except with economically smarter, better-timed spending cuts and revenue increases.

Last week the Tax Policy Center (TPC) released an analysis and held an event (which I participated in) on the tax changes that comprise the so-called “fiscal cliff”–the combination of policies scheduled under current law that according to the Congressional Budget Office (CBO) in their latest budget outlook would reduce the federal budget deficit by around half a trillion dollars between fiscal years 2012 and 2013.  (CBO had also done this earlier analysis in May (based on their previous baseline forecasts) focused specifically on the economic effects of avoiding or reducing the 2013 fiscal cliff.)

I’ve made the point before that the scary part of the “cliff” that everyone is talking about and wants to avoid is just the first year of the current-law baseline; the drop from deficits in fiscal year 2012 to the baseline deficits in fiscal year 2013. CBO themselves referred to this one-year fiscal contraction as enough to send us back into recession:

Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013.

While it is thus understandable that everyone says we can’t “go over” (or “run into”) the cliff, that doesn’t tell us what we should do on the other side of the one-year cliff.  Are we going to reject the entire current-law baseline in favor of “business as usual” that continues to extend and deficit finance the type of spending and tax cuts we’ve enjoyed over the past dozen or so years?  Or are we going to try to get back on the current-law baseline path eventually, given that CBO says that not doing so–continuing to avoid the cliffs and kick the cans along the way–would be harmful to the economy later on? (emphasis added):

Under the alternative fiscal scenario, deficits over the 2014–2022 period would be much higher than those projected in CBO’s baseline, averaging about 5 percent of GDP rather than 1 percent. Revenues would remain below 19 percent of GDP throughout that period, and outlays would rise to more than 24 percent. Debt held by the public would climb to 90 percent of GDP by 2022—higher than at any time since shortly after World War II.

Real GDP would be higher in the first few years of the projection period than in CBO’s baseline economic forecast, and the unemployment rate would be lower. However, the persistence of large budget deficits and rapidly escalating federal debt would hinder national saving and investment, thus reducing GDP and income relative to the levels that would occur with smaller deficits. In the later part of the projection period, the economy would grow more slowly than in CBO’s baseline, and interest rates would be higher. Ultimately, the policies assumed in the alternative fiscal scenario would lead to a level of federal debt that would be unsustainable from both a budgetary and an economic perspective.

Note that most of the difference between “take the cliff” or current law and “avoid the cliff” or “alternative fiscal scenario” is tax policy; CBO’s figures for the one-year decline in the deficit under current law show that higher revenues alone account for $478 billion, or 98 percent, of the $487 billion “cliff.”  Alternatively, if defined as the difference between current-law and policy-extended (business as usual, alternative fiscal) deficits in fiscal year 2013, higher revenues account for 83 percent of the difference ($330 billion of $396 billion).

Thus, it’s pretty important that we take a closer look at the tax policies that comprise the “fiscal cliff,” in order to address it in the best way not just over the next year (when we want to avoid it because of the recession factor) but in the future (when we want to come closer to embracing it for long-term economic growth reasons).  The Tax Policy Center’s analysis is very helpful in this regard, effectively pulling apart the pile of fiscal cans that have all been kicked to this particular point in time (the end of 2012) and studying the tax-policy labels on each one of the tax-policy cans (that are most of the cans).  See, I believe the approach we need to take is not to simply avoid the fiscal cliff and kick the whole pile of current-law policy cans away (either into the trash or yet again “down the road”), but to commit to honoring the mix of spending cuts and (mostly) revenue increases imbedded in those fiscal cans and the current-law baseline, without feeling stuck with the particular timing and shape of the revenue- and spending-side policies.  What I mean is that we should strive to achieve (and committo achieving) the same amount of deficit reduction over the 10-year budget window as is implied by the current-law baseline, and even the same amount achieved via the spending side vs. the revenue side of the budget–except with economically smarter, better-timed spending cuts and revenue increases.  I think of this as “recycling the cans” instead of continuing to kick them.  If we can’t use them usefully now, in their current spending-cut or revenue-increase form, let’s carry them along with us as we go along and figure out how to use them better later.  But the rule is that we have to use them; we aren’t allowed to trash them.

The Tax Policy Center analysis takes apart the pile of fiscal cans and sorts the current-law tax increase cans according to their “likelihood of occurring”–basing this admittedly very subjective ranking on “public discussion, proposals advanced by the two presidential candidates and members of Congress, and past congressional actions.”  This ranking is because TPC is trying to show the effects of what is most likely to happen–basically, what to expect when expecting our dysfunctional political and policymaking processes to continue. Here’s that list, from the tax increases they judge as most likely to occur (tax cuts most likely to expire) to those they judge as least likely to occur (tax cuts most likely to be extended)–see the TPC report for description of the policies in each category:

1. Payroll Tax
2. Health Care Law Provisions
3. High-Income Capital Gains and Dividends
4. High-Income Rates, Pease, and PEP
5. Stimulus Legislation EITC, CTC, and AOTC
6. Extenders
7. Estate Tax
8. 2001/2003 Tax Provisions Primarily Affecting Low- and Middle-Income Households
9. Alternative Minimum Tax Patch

The TPC analysis demonstrates that we’re facing significant tax increases over the next year under current law, and that even if policymakers opt to avoid significant portions of the impending fiscal cliff, any parts of the cliff that do occur are likely to involve higher tax burdens on almost all of us (at least 90 percent of us), because the most likely tax increases to occur are some tax increases on mostly lower-and-middle-income households (such as items 1 and 5) and only some on just higher-income households (such as items 2, 3, and 4).

But TPC’s ranking of the “likelihood” of the tax increases above shouldn’t be taken as their endorsement of that policy ranking.  What if TPC had chosen to rank the policies according to economic intelligence instead–or how they would do it if their economists (or other smart economists) had their say?  That is, what if TPC had adopted my “recycle the cans” approach and tried to put out a ranking to guide policymakers on how to bestdeal with the tax-increase cans–from an economic perspective?  This kind of ranking would have to change over time, based on economic conditions at the time.  Right now, the entire fiscal cliff is a scary proposition because in an economy still in recovery, still facing a shortage of demand, any form of fiscal contraction can worsen conditions (as the CBO warning of “recession” underscores).  But ranking the tax increases from least harmful to most harmful, we economists would prioritize and use the tax-increase cans this year differently.  We would either avoid using any cans this year, or we would use the tax-increase cans that increase burdens on just the richest of households first–so we would probably rank tax increases 2, 3, 4, and 7 in the TPC list as the least harmful to the economy and the hence the most acceptable to exercise first.  We would push tax increases 1, 5, and 8 (the more regressive or proportional tax increases) further down this year’s list, because those are tax increases more likely to adversely reduce demand and suppress job creation.  Or we would simply replace this year’s scheduled regressive tax increases with other more progressive, less harmful to demand, tax increases–”recycling” the tax-increase cans (by changing their timing or shape) while keeping their essential revenue-raising element.

But on the other hand, an economist-determined ranking of these tax policies would change once the economy got back to full employment, a couple years out (hopefully).  In a full-employment economy, economic growth becomes once again constrained by the limits of our productive capacity, or the “supply side” of our economy–how large our human and physical capital stock is, and how intensely and efficiently we are choosing to use it.  Under those full-employment conditions the adverse influence of higher marginal tax rates on labor supply and saving, and uneven effective tax rates across different sources and uses of income, will matter relatively more than they do now in our currently-still-demand-constrained economy.  So in a couple years when we reexamine the tax-increase cans we have yet to use or re-purpose, we economists may rank tax increases that are skewed heavily to the rich and in the form of higher marginal tax rates much lower than we might this year.  At that time we economists will also likely press harder for “base broadening” revenue increases that would raise effective burdens on all taxpayers, not just on the rich, because in a full-employment economy we will be more concerned with minimizing tax policy’s distortions on economic decisions than on steering more cash to the most cash-constrained households or businesses (who won’t be as cash-constrained at that time).

So my idea is to stop “kicking the can(s)” and instead follow a “recycle the cans” approach.  Stop rejecting the current-law baseline levels of revenues and instead more strongly embrace them, because: (i) those revenues lead to economically-sustainable deficits over the next 10-20 years and represent a “grand bargain,” “go big” level of deficit reduction; (ii) those are policies our policymakers actually agreed to (to let tax cuts expire); and (iii) contrary to the spending-side portions of the current-law baseline, which we haven’t really experienced before, we have lived through the revenue-side portions (as in Clinton-era tax policy).  Whatever parts of current-law revenues we can’t tolerate at the moment, save them for future, more thoughtful revenue increases–don’t just abandon them.  And get the budget committees and the budget process to enforce this commitment.  “Recycle As You GO” (or “RAYGO”) can be the new budget mantra.  It sounds easier and more resourceful than “PAYGO,” doesn’t it?