Fiscal Cliff 2013: Debt Reduction and Cliff Avoidance Are Two Separate Issues

The fiscal cliff negotiations are failing because both parties are seeking to solve too many problems in too short a time frame. The fiscal cliff and plan for long-term debt reduction are two totally separate issues, which call for solutions inherently opposed to one another. These solutions include raising taxes on everyone, and reducing entitlement programs. To achieve these goals, we need congressional bipartisan cooperation and presidential leadership.

Simply put, to avoid the cliff, Congress needs to find a way to tax less (by extending most rates) and spend more (by maintaining current outlays). Long-term debt reduction, on the other hand, calls for narrowing budget deficits through higher revenue and lower levels of spending.

Why are we trying to do both at the same time? I belief most of the fault for this strategy lies with the GOP, but the Democrats share some blame as well.

A month or two ago I would have agreed with most people who claimed, "We can't kick the can down the road any longer. Long-term debt needs to be reduced along with our efforts to avoid the cliff." Congress has missed that window of opportunity.

As of Sunday, there are twenty-one days left until we reach the cliff at which time, most economists agree, a recession is imminent. Congress is incapable of reaching an agreement on both issues by that January 1 deadline.

The GOP insists that any increased tax revenue must be raised in conjunction with cuts to spending. This is a foolish demand and an irresponsible threat to the fragile recovery. Firstly, all income earners will have to eventually pay higher tax rates, not just the top 2%.

The Bush era tax cuts were passed without equally offsetting spending cuts. In fact, the U.S. launched two wars overseas while lowering taxes. That colossal mistake must be rectified before broader discussions continue on spending cuts. Tax rates should rise for all wage earners in the next couple of years back to Clinton era levels.

From 2009-2011, revenues as a percentage of GPD were less than 16%. Marc Labonte from the Congressional Research Service gave a detailed breakdown of revenue shortfalls for the past decade in his report titled, "Reducing the Budget Deficit: Policy Issues" (2012). "In 2009 and 2010, revenues were at historically low shares of GDP across all major categories -- individual income taxes were at their lowest share of GDP since 1950, corporate income taxes were at their lowest share of GDP since the 1930's, social insurance receipts were at their lowest share of GDP since the 1970's, and excise taxes were at their lowest share of GDP since 1934."

See the graph below titled, "Figure 2. Federal Revenues and Outlays, Historical and Projected Under the Alternative Fiscal Scenario: 1946-2022". It shows the sharp divergence between revenues and spending beginning in 2001. Coupled with the 2006-07 recession, unsustainable deficits have persisted for a decade. Tax rates need to rise as a share of GDP for everyone, but at different stages. 

The top 2% of income earners can afford higher rates right now, meaning they can withstand that immediate shock far better than the middle class can. The rich should find closure in a forthcoming Democratic pledge to raise all rates when economic conditions allow. And the Democrats need to offer that pledge.

What type of conditions should we look for? When nominal GDP and nominal wage growth have risen to sustainable levels for the middle class. I say nominal rates instead of real rates because moderate inflation can be offset by responsible spending habits. If the price of oil rises sharply, the middle class can, and often has, car pool or ride the bus to work, thereby partially shielding themselves from the effects of inflation while at the same time enjoying higher, nominal wages. 

The Democrats deserve blame for their unwillingness to discuss cuts to entitlement programs. They must be reformed soon, period. Democrats know this, but they refuse to anger their constituents by acting decisively. Medicare, Medicaid, and Social Security alone account for the highest percentage of federal spending and, therefore, are the most significant factor in widening deficits.

From 2009-2011, mandatory spending accounted for roughly 13% of GDP, and that trend will only continue in the future. Labonte explains, "In contrast to discretionary spending, mandatory spending is projected to continue to grow faster than inflation and exceed 13% of GDP over the next ten years".

Expressed as a share of 2011 federal outlays, that's 50% of total spending. As a side note, the portion of mandatory spending hated most by ill-informed conservatives, Income Security (a.k.a welfare), is projected to decrease from "438 billion in 2010 to an annual average of $302 billion over the next ten years." Our elders are draining the coffers. 

In order to assuage the concerns of the GOP, the Democrats need to offer credible plans for entitlement reform. Entitlements will bankrupt the United States of America, and no amount of taxation will help the country avoid that fate. Plans such as, but not limited to: auctions for pharmaceutical contracts; older retirement age qualifications; higher premiums; more cost effective medical treatment and delivery; more responsive cost-of-living adjustments, need to be pursued. 

The GOP is holding the line on higher taxes for the rich because its members remain suspicious of Democratic resolve for overhauling entitlement programs. But if the Democrats were more forthcoming, and if the GOP suddenly realized that entitlement reform is inevitable, not just likely, then they would likely compromise today.

President Obama and Treasury Secretary Geithner deserve most of the blame for failing to divorce the fiscal cliff negotiations from long-term debt reduction goals. Granted, Secretary Geithner courageously advocated linking the two issues together, but he did so weeks ago when linkage seemed reasonable.

The January 1 deadline, however, is fast approaching, and what should have been a simple agreement to avoid a recession has been delayed by obstructionists. 

A two-track approach should aim to avoid the cliff by January 1 while ongoing long-term debt negotiations continue through the new year. In order to lend more credibility to the latter, however, binding agreements should be made now upon a prioritized list of entitlement reforms.

In this way, the Democrats would show their willingness to tackle the leading causes of long-term deficits in exchange for Republican short-term concessions on revenue increases made before January 1. Both parties need to break away from the demands of their constituents because those demands are irrational.

Obviously the rich will reject higher rates of taxation. Obviously the elderly and poor will reject cuts to their benefits. From their vantage point, these self-interested demands seem rational. But if we look at U.S. fiscal policy as a whole, these self-interested demands look irrational because they undermine the very financial system which enables them to enjoy their benefits. 

Both parties are failing to fulfill their responsibilities. The public has lost faith in Congress. The business community is similarly disgusted with the government. Entrepreneurs and CEO's are hoarding cash and choosing not to hire until Congress reaches agreement upon these two important but separate issues. The most troubling facet of this entire fiasco is a lesser discussed opportunity — the U.S. is poised for a strong recovery, balanced growth, and the reinvigoration of its workforce. 

Today there are forces aligning with one another to support the fragile recovery: unemployment is decreasing; nominal wages are increasing; the holiday season is upon us; the housing market is recovering; and household debt (excluding student loans) is being paid down.

Collectively, these encouraging developments provide the impetus for a robust recovery, but a catalyst for real growth is needed. That catalyst is a combination of serious congressional bipartisanship and presidential leadership. Neither exist. While falling over the fiscal cliff would have serious economic effects, the damage to society would be catastrophic. 

Confidence in republicanism hasn't hit rock bottom yet, and the political divisions between Conservatives and Liberals can widen much farther. Congress knows had to avoid this calamity, but seems unwilling to take incremental steps to avoid it. Avoid the cliff, then fix the fiscal house.