America's fiscal policy faces an apparent Hobson's choice. On the one hand, we need to tame federal deficit spending by imposing new across-the-board spending cuts and higher taxes. We are told that if we do not act on this soon, the debt markets will choke on the overabundance of government debt issued to fund those deficits, causing interest rates to climb. As a result, businesses and homeowners will be unable to borrow on reasonable terms, which will lead to a slowdown of the economy.
On the other hand, we also are told that allowing this deficit reduction program actually to take effect in 2013 would precipitate a new recession.
Faced with two genuinely unpalatable courses of action, it's no wonder that Washington struggles to find a consensus.
But, the dilemma is more apparent than real, because it confounds the dimension of time.
What we need to do is to commit today to a transition -- a ramp -- from our current taxing and spending policies to a more sustainable mix. A firm congressional commitment, for example, to a three-year ramp, by means of which we move to a sensible combination of higher taxes and lower spending, should enable the economy to heal while reassuring markets that the long-term fiscal health of the country will be restored.
Of course, advocating a three-year transition from where we are to where we need to be is the easy part. The real challenge is to identify the new policies.
A bona fide "grand bargain" might need to encompass as much as $8 trillion in lower spending and higher taxes over 10 years to address fully the underlying fiscal trends, not the much smaller numbers currently bandied about. Figuring out how to do that will be extremely painful for Congress, because regardless of party affiliation, members like to give more than they like to take away.
The genuine difficulty of defining the new mix of taxing and spending policies that will apply at the end of the ramping-up period means that negotiations will take a great deal of time. But our dilemma reminds us that we do not have the luxury of time to thrash out all the components of this sustainable path, if we are to avoid an immediate recession.
We have to define the ramp to a new fiscal policy without being sure exactly what those new taxing and spending rules will be. This sounds impossible: How do you build an off ramp from a highway to connect to another road that does not exist and has not yet even been mapped?
There is a way to do just that. First, let all the Bush tax cuts and other temporary tax discounts expire (which is what legislative inaction will trigger on January 1), but phase in the expiration of the Bush tax cuts over three years (so that a third of the extra tax bite is added each year). At the same time, repeal the $1 trillion of new across-the-board spending cuts (the "sequestration") to which Congress committed itself when the budget "supercommittee" failed.
These two steps define the ramp. The repeal of the spending cuts adds to the deficit but is far outweighed over time by the incremental taxes that would be raised if all the Bush tax cuts expired.
The nonpartisan Congressional Budget Office projects that those higher tax revenues largely solve the deficit problem over the next 10 years or more. The resulting tax system can simultaneously be improved, for example by eliminating the hated Alternative Minimum Tax, without any further revenue costs through a few surgical strokes I have advocated before.
Then, let Congress do what it does best, which is to cut taxes starting three years from now -- but with a catch. The deal must be that Congress bind itself in advance automatically to apply new spending cuts (compared with the budget office's projections) to tax rate rollbacks. So, for every $1 billion reduction in government spending, Americans' tax bills automatically would be cut by $1 billion.
Those tax rate rollbacks should start with the lowest tax bracket first. The reason for this ordering is that all taxpayers, rich and poor alike, get the benefit of the lower tax brackets on their income in that bracket. By buying down tax rates from the bottom up, the proposal shares the savings from new government spending cuts across the broadest possible number of Americans.
Under this proposal, the ramp up to a sustainable budget would be set in advance (through the three-year staged repeal of all the Bush tax cuts), as would the way to lighten the load without deviating from the path's ultimate goal of fiscal sustainability (through spending cuts automatically applied to buying down those scheduled tax rate hikes).
Given this opportunity, both parties will have strong incentives to agree to spending cuts, because each net spending reduction will bring new tax relief to constituents. If Congress enacts large enough spending cuts, all the tax rate hikes would automatically roll back.
Over time, Congress will reach a balance between new taxes and reduced spending through negotiations that offer members a positive reward -- tax relief -- to counterbalance the bitter pill of spending cuts. But the key is that those scalebacks in government spending programs do not have to be identified before this Christmas; as each is enacted in the months or even years to come, the automatic mechanism would deliver tax rate rollbacks to Americans.
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