Op-Ed: The "Go Fast" and "Go Big" Fiscal Challenges

New York Times | November 30, 2012

Washington faces two urgent fiscal challenges in the next few months. Before the end of the year, the lame duck Congress, the most polarized in recent history, must negotiate an agreement with President Obama to protect the still fragile economic recovery from the so-called fiscal cliff — the $600 billion in spending cuts and tax increases scheduled to begin to take effect on Jan. 1. Then, early next year, a newly elected but still divided Congress must approve an increase in the federal debt limit. Failure to do so in a timely way would damage confidence, posing yet another threat to the economy’s continued healing.

These two challenges are manifestations of the long-running fiscal challenge confronting the country: the fact that the federal debt is rising at an unsustainable rate. That’s why a political deal to address the fiscal cliff and the debt limit in the near term should be linked to a credible framework to put fiscal policy on a sustainable path in the long term.

By the end of this year, policy makers need to “go fast” to address the fiscal cliff and debt limit and to “go big” to establish the broad outlines of a significant multiyear deficit-reduction plan.

The economy continues to operate far below its capacity. The unemployment rate is at least two percentage points higher than what most economists consider consistent with a full recovery. Other measures, such as the high rate of long-term unemployment and the low labor-force participation rate, reflect an impaired labor market

According to the Congressional Budget Office, gross domestic product is still about 6 percent, or about $973 billion, below the potential level the economy is capable of producing at full capacity. This is the largest gap between actual and potential output following a recession in modern American history.

The weakness of government spending at the state and local level and more recently at the federal level has been a significant factor behind the slow recovery. The phasing out of earlier federal stimulus measures, the expiration of temporary payroll-tax relief and extended unemployment benefits scheduled at the end of the year, and the tight caps on discretionary federal spending already in force mean more federal fiscal drag on the economy’s growth next year even if the fiscal cliff is averted

Ideally, given the shortfall in aggregate demand that is keeping the economy stuck below potential, a deal on the cliff should include an extension of both payroll tax relief and unemployment benefits, as well as other temporary policies to support job creation, such as the employment tax credit for small business and the increase in infrastructure spending proposed last year by President Obama as part of the American Jobs Act.

Alas, it seems unlikely that a deal will contain these measures. At best, if a deal is reached it will probably be limited to tabling the deep spending cuts automatically scheduled to take effect early next year, extending the 2001-3 tax cuts for the bottom 98 percent of taxpayers and raising taxes on the top 2 percent of taxpayers, especially those with incomes over $1 million, through some combination of higher marginal tax rates and caps on deductions.

To improve the economy’s near-term growth prospects, the deal should also contain a promise that Congress will approve the debt limit when necessary without a destabilizing delay.

So far, negotiations about a go-big framework for deficit reduction have focused on cutting at least $4 trillion from the federal budget over the next decade, with the goal of stabilizing and then reducing the debt-to-G.D.P. ratio. The election and recent Gallup polls settled the debate about whether an increase in revenues will be part of the plan. The answer is yes.

The debate has shifted to how revenues should be increased and who should bear the burden. The proposition that revenues should be raised through tax changes that limit deductions, credits and loopholes, in lieu of or in addition to rate increases, is gaining momentum.

Economists believe that raising revenues for deficit reduction through base-broadening tax reforms is probably better for economic growth than raising marginal tax rates.

Although it may prove politically necessary for a bipartisan deal, however, there is no convincing economic justification for using some of the revenues saved from tax reforms to lower marginal income tax rates for high-income taxpayers. These rates are already at historic lows.

And there is no convincing evidence that real economic activity responds materially to changes in these rates, at least within the range of rates experienced in the United States during the last half-century. The tax code should be reformed to make it simpler, fairer and less distortionary and to raise revenues for deficit reduction, not to reduce tax rates on high-income taxpayers.

Over the last 30 years, income inequality in the United States has increased sharply. During the same period, the federal tax system has become less progressive and has contributed to the trend of rising income inequality and widening opportunity gaps between children born into different income groups.

A more progressive tax code, achieved through some combination of higher tax rates and capping deductions for high-income taxpayers, would be a powerful tool both to counteract these trends and to achieve long-term fiscal sustainability.

On the spending side, “go big” bipartisan proposals for deficit reduction, such as the Simpson-Bowles and Domenici-Rivlin plans, focus on curbing the growth of Medicare, Medicaid and Social Security. This is understandable as these programs already account for about 40 percent of federal spending and that share is projected to rise as a result of the aging of the population and the growth of health care costs.

But lumping Medicare, Medicaid and Social Security together is misleading and, given strong partisan passions on Social Security, could weaken the chances of reaching a bipartisan deal on deficit reduction.

Spending on Social Security is rising primarily because of demographics, not because of growing benefits per eligible person. Indeed, the Social Security Trust Fund has adequate resources to cover benefits until at least 2033, and the program’s revenue shortfall is less than 1 percent of G.D.P. over the next 75 years.

In contrast, the argument for including Medicare and Medicaid in a framework for long-run deficit containment is compelling. The single most important factor behind the projected growth in federal spending is the growth in health care spending, driven primarily by the growth in Medicare spending per beneficiary.

The outlook has already improved as a result of significant changes in the delivery and payment of health care services in the Affordable Care Act. As a result of these changes, growth in Medicare spending per enrollee is projected to slow to 3.1 percent a year during the next decade, about the same as the annual growth of nominal G.D.P. per capita and about two percentage points slower than the annual growth of private insurance premiums per beneficiary.

Speeding up the pace of the Affordable Care Act changes along with others, such as reducing subsidies for high-income beneficiaries and drug benefits and introducing small co-pays on home health-care services, would mean even larger Medicare savings.

A “structural reform” popular among Republican deficit hawks like Representative Paul Ryan of Wisconsin to convert Medicare to a premium-support or voucher system would be counterproductive and would drive up both spending per beneficiary and overall costs in the health care system.

The goal of a “go big” plan for deficit reduction should be to ensure the economy’s long-term growth and competitiveness. Yet the debate over spending in Washington is fixated on cutting entitlement spending. Very little is heard about the need to increase federal spending in education and training, research and development and infrastructure, three areas with proven track records in rate of return, job creation, opportunity and growth.

Spending in these areas accounts for less than 10 percent of the federal budget; this share has been declining for several decades and is slated to fall to dangerous new lows as a result of the caps on nonmilitary discretionary spending already in place.

A pro-growth framework for deficit reduction must reverse these trends. More government investment in the foundations of economic growth should be recognized as a core principle of deficit reduction.