Fiscal Cliff 2013: Congress Can Avoid Another Economic Crisis, Here is How

Neither President Obama or John Boehner, the Speaker of the House of Representatives, have insisted on the extreme positions they held during debt talks last year. This is encouraging and leaves both parties with room to compromise. “[The absence of these extreme positions] has aroused hopes that the two men can find common ground on tax reform that leaves marginal tax rates where they are while raising new revenue by curbing credits, deductions and exemptions (collectively called tax expenditures) which distort economic activity.”

The term “tax expenditures” sounds like a contradiction, right? Life’s full of contradictions, so here’s an explanation from BusinessDictionary.com: “[Tax expenditures are] revenue a government forgoes through the provision of tax laws that allow (1) deductions, exclusions, or exemptions from the taxpayer’s taxable income…”

Let’s look at the implications of that definition. Tom, Mary and Jen are the only three citizens of a fictional town called Nowhereland. They have different jobs, and their annual income is as follows: Mary – $100,000; Tom – $80,000; Jen – $40,000. After years of haggling, Tom, Mary and Jen chose the following tax rates to fund their expenditures: Mary – 39%; Tom – 34%; Jen – 25%. So in any given year Nowhereland raises $76,000 in revenue (39,000+27,000+10,000).

Nowhereland uses this annual revenue to maintain the town’s only road, gymnasium, public park and — most importantly — to make payments to the elderly from the town’s retirement fund. The exact expenditures aren’t critical. For the longest time Nowhereland managed to meet its expenditures with its annual revenue. But something occurred a few years ago which changed everything: Mary and Tom conspired with one another to pass legislation that would relieve them of a portion of their taxes.

The deduction they fashioned was an “industry exemption” which rewarded individuals who produced manufactured goods. Miraculously, Tom and Mary immediately qualified for the very deduction they had created! Unfortunately, Jen did not qualify. The deduction allowed Tom and Mary to keep 3% of their annual income which they used to pay as taxes. That works out to $3,000 for Mary and $2,400 for Tom, or $5,400 for the two of them.

Good for them, right? Sure, but Nowhereland now faces a revenue shortfall.

The town’s updated annual revenue has slipped from $76,000 to &70,600 for the year following the passage of the “industry exemption.” The three citizens had a decision to make: how can we either (1) raise the $5,400 or (2) cut $5,400 from our expenditures to pay for the deficit? They chose to cut first. All said and done, they were able to find $2,700 in cuts to service, leaving Nowhereland with an updated deficit of $2,700. Keeping growth the same, and refusing to raise taxes, Nowhereland was forced to borrow $2,700 from their neighbors at 5% interest, or $135 to be paid the following year.

One year later Nowhereland repaid the $2,700 loan and $135 interest payment. Here’s a crucial point: That $135 will never be seen again, and it has to be automatically included in an updated list of expenditures. So, assuming Nowhereland maintained the same $2,700 in cuts as the year before, and if you add the $135 to expenditures, the town had a budget deficit of $2,835.

Refusing tax hikes another time, Nowhereland had to borrow the balance from their neighbors again. But the principal balance of $2,835 meant that a 5% interest payment would now stand at $141.75, not $135. But wait! Jen had her 60th birthday in January and now qualifies for annual payments from the elderly retirement fund. Every month, like clockwork, she will now receive a check for $20. Annually that’s $240. All things considered, Nowhereland’s updated budget deficit for the year is $3,075. The interest on that loan would be $153.75.

Do you see the problem? Even if Nowhereland decides to raise tax rates across the board, Mary and Tom will still enjoy their tax exemption. The value of their taxes paid will be roughly equal to what they used to pay before the “industry exemption” was passed, but Jen has to pay a higher rate, enjoys no such exemption, and therefore experiences a negative wealth effect: She has become poorer. On top of her deteriorated income, Jen also lost access to the services Nowhereland cut a couple of years ago during the town’s debt talks.

But let’s pretend Mary and Tom fought efforts to raise more revenue through higher rates and the elimination of their expemption. Nowhereland never seemed able to avoid borrowing money from their neighbors to pay for their annual deficit. Bonds were issued for the next 10 years to cover a principle value that grew every year. The 5% interest rate continued to leave Nowhereland with a growing expenditure that was mandatory and that left the town with less services.

Then came the real surprise. Nowhereland’s neighbors grew suspicious of the town’s ability to meet their debt obligations. The neighbors thought the bonds were riskier than before and demanded 7% instead of 5%. Again, refusing to raise tax rates, and running out of services to cut, Nowhereland had no other choice but to borrow money from their neighbors and pay a higher interest rate.

Coupled with that development, a war erupted across the ocean which strangled the supply of oil which Nowhereland used to power their electrical grid. The price for a barrel of oil doubled and stayed that high for another ten years. These two developments translated into a growing portion of the town’s expenditures being spent on mandatory interest payments and the importing of oil. The road began to crack, increasing the time it required to deliver products to market. The town park became overgrown with weeds and the jungle gym rusted beyond repair. The lights above the market could only stay on for two hours a day.

The day of reckoning finally arrived. Nowhereland’s neighbors refused to lend the funds necessary to service the town’s suffocating deficits. The town’s constitution explicitly prevented the governing body to surpass a deficit of $10,000 which Nowhereland was fast approaching. Mary and Tom finally gave in to some of Jen’s demands. Tax rates were raised proportionately and all of the services were cut. But the “industry exemption” was not repealed despite the fact that it represented 54% of Nowhereland’s deficit. As tax rates continued to rise, Jen could no longer invest in her business nor pay for the cost of oil. She closed her business and Nowhereland lost the $10,000 in annual revenue.

Although a simplified and dramatic version of today’s debt talks, Nowhereland’s demise reveals the distorting effect deductions and exemptions have upon budget plans. The exact mix of cuts and revenue raising measures that will emerge from the debt talks should be well balanced. But if raising tax rates is such an abhorrent idea for conservatives, then they must give in on tax reform via the elimination of many deductions and exemptions.

Of course, closing these loopholes isn’t a panacea: Some tax rates must go up, cuts must be made, and economic growth has to be fostered through the easing of regulations. Businesses need to be confident that changes made in the upcoming weeks will be sustained. It is impossible to engage in industrious investments when the political landscape — and therefore the business climate — is uncertain. Confronted with debt talks and tax reform that are shrouded in mystery, business owners will continue to hoard cash.

President Obama, like every other second term president, will seek to fashion a popular legacy. The most effective way to do that is to deliver economic growth. The moment he secured his re-election was the moment that President Obama no longer had to answer to the radical, progressive wing of the Democratic Party. Likewise, the GOP is in disarray, and Republicans are all too aware of the fact that ultra-conservative platforms threaten political suicide. Boehner is moving the House closer to the middle, while Obama is leading Harry Reid’s Senate to the middle.

The country resembles Shroedinger’s Cat: dead and alive at the same time. Or in political terms, the parties are more divided than ever, but unified in their exhaustion with extreme politics.

This article originally appeared on The Internationalist at Hawk.