Fiscal Cliff an Opportunity to Correct Fiscal Imbalances

A point that I've repeatedly made on this site is that the U.S. government has both a spending problem and a revenue problem.

In the last fiscal year, the government collected 15.5 percent of GDP in revenue and spent 22.4 percent. That's a considerable problem and it cannot continue.

Due to high unemployment plus lower incomes and wages, tax revenues have plunged from their historical average of !8 percent of GDP. As a share of GDP, income tax revenues are at their lowest level since 1951, when Harry S. Truman was president.

To offset this lack of private demand, the government increased expenditures to fill the void and undergird the economy. Yet, that has grown the government to excessive proportions, which is not good for the long term health of the economy.

A 1998 Congressional Joint Economic Committee study concluded the optimal size of government to maximize economic growth was about 18% of gross domestic product. The government is now spending well above that.

Washington's profligate ways go back many years.

Over the forty years ending in 2008, federal revenues averaged about 18.3 percent of our economy, while spending averaged over 20.6 percent, resulting in an average deficit of about 2.4 percent. Since 1970, the Federal Government has run deficits for all but four years (1998–2001).

All those deficits have added up to a national debt that now exceeds $16 trillion, and counting. Medicare and defense spending are the biggest drivers of the government’s continual deficits and massive debt.

The U.S. dedicates 18% of GDP to healthcare — the greatest share of any nation in the world and about twice as much as other industrialized nations.

By the end of the Congressional Budget Office’s 10-year budget forecasting period in 2022, Medicare outlays will be more than $1 trillion a year. For the entire ten-year period, 2013-2022, Medicare will cost taxpayers $7.7 trillion.

However, American workers pay a Medicare tax (separate from the income and FICA taxes) that funds the hospital insurance system, which provides medical benefits to eligible individuals upon reaching age 65. That tax may be raised, or benefits lowered, to counter shortfalls. The same is not true with military spending.

Pentagon spending accounts for over 50 percent of all discretionary spending in the federal budget, and overall security spending constitutes two-thirds of the discretionary budget, according to the CBO. Military spending has tripled since 1997. Simply put, the Defense budget is bloated and wasteful.

According to estimates by Nobel Prize-winner Joseph Stiglitz and Professor Linda Bilmes of the Harvard Kennedy School, when all the costs are counted, the Iraq invasion and the Afghan war will each cost US taxpayers $3 trillion dollars. Both were unfunded. In other words, the two wars doubled the U.S. public debt.

When all defense-associated spending is added up — including the Defense Department, Overseas Contingency Operations, the Department of Veterans Affairs and the Department of Homeland Security — all of the mandatory and discretionary programs amount to a whopping $877.9 billion annually, according to the Office of Management and Budget.

And this doesn't even include the money dedicated to the Department of Energy to maintain the nation's nuclear weapons arsenal.

Based on the Government Accountability Office’s latest long-range alternative budget simulation, by the end of this decade our interest payments will become the largest single expenditure in the federal budget. By 2040, all of our federal tax revenues will add up to cover only our two biggest expenses: interest on our debt plus Medicare and Medicaid. Everything else — Social Security, defense, education, road building, you name it — will fail to be funded.

Washington has finally accepted that it has a significant problem that can no longer be ignored and passed on to the next group of legislators. Negotiations are underway to avoid the fiscal cliff. Congress will also have to negotiate another raise of the debt limit. Furthermore, Congress hasn't even passed the fiscal 2013 budget, which was submitted by the White House back on February 13th.

It's worth noting that the fiscal year began on October 1st and runs through next September. So, the government has been operating for more than two months (one-sixth of the year) without a formalized budget.

One of the big sticking points in negotiations to avoid the fiscal cliff is President Obama's insistence that income tax rates go up for the wealthiest Americans. Most congressional Republicans are against that idea.

House Speaker John Boehner claims that raising taxes on the top 2 percent of income earners would be unfair because half of those taxpayers are small business owners who pay their taxes through their personal income tax filing each year.

The Speaker made that assertion again this week. Yet, Boehner has been repeatedly corrected on this by fact-checkers. In fact, the Speaker's office says that he misspoke when he made that claim this week, although it's a misstatement he's made more than once.

Last year, some analysts at the Treasury Department took a closer look at what constitutes a small business, and they defined them as those making up to $10 million.

They excluded all those that were making over $10 million. At the other end, they threw out people who might have a big salary from a day job and then a little small business on the side.

When they narrowed the definition that way, what they found was about one in five taxpayers in those top two brackets is a small business owner. And of all the income in those brackets that would be taxed at a higher rate, only about 7 percent comes from small businesses.

Republicans say that raising tax rates on the highest earners would result in a loss of jobs.

However, when the Congressional Budget Office looked at what the affect of raising those taxes would be on jobs, they found it'd really be pretty tiny — about 200,000 jobs over the course of a decade. That's about as many jobs as the economy has been adding in one or two months.

Additionally, a recent report by the non-partisan Congressional Research Service (CRS) found no correlation between top tax rates and economic growth, a central tenet of conservative economic theory. Specifically, the report found that there is no evidence that tax cuts for millionaires and billionaires leads to improved economic growth. The CRS analysis compared tax policy with GDP patterns over the last 65 years.

The report was first released in September, but was removed from public circulation shortly thereafter because Senate Republicans objected to the findings.

Republicans say any new revenue should be raised by curbing tax breaks.

Given that 45 percent of U.S. households do not pay income tax (either because they don’t earn enough or through credits and deductions) and 3% of taxpayers contribute around 52% of total tax revenues, a major overhaul of the U.S. taxation system is in order. In fact, eliminating tax breaks may ultimately be a better, fairer way to raise more revenue.

The problem is that anti-tax crusaders like lobbyist Grover Norquist, and his Republican adherents in Congress, have insisted that any tax reform which reduces or eliminates write-offs, deductions and exemptions must be revenue-neutral. If that's the case, then what's the point? This cannot be an exercise in futility amounting to nothing more than simply rearranging the deck chairs.

Simply increasing tax rates on the wealthiest Americans would not raise enough revenue to address the nation's fiscal crisis. Additional measures are needed.

If the Bush tax cuts were allowed to expire on couples whose income is over $250,000 and singles over $200,000, it could raise close to $1 trillion over 10 years, according to Tax Policy Center data. Allowing the Bush tax cuts to expire on income over $500,000 ($400,000 for singles) could raise at least $315 billion over a decade. And if the Bush tax cuts were allowed to expire on income over $1,000,000, at least $242 billion could be raised.

As you can see, squeezing additional revenues from only the very wealthiest Americans results in increasingly diminishing returns.

To truly get at the revenue problem, all of the numerous tax loopholes must be closed and deductions eliminated. Lobbyists have spent the past couple of decades getting favored status for their varied interests and layering the tax code with assorted breaks, deductions, write-offs and loopholes.

After all, what's the point of tax brackets if the effective rate people are paying is less than that written into law?

Republican Senator Bob Corker of Tennessee has circulated a proposal to cut the deficit by $4.5 trillion over 10 years. Corker would address entitlements by gradually increasing the age for Medicare and Social Security eligibility and would lower cost of living increases for Social Security.

As for taxes, Corker would not raise rates, but would cap itemized deductions at $50,000. The senator says there are $1.2 trillion in loopholes and deductions in the tax code at present. His hope is to "simplify the code."

Corker says his proposal, "keeps rates where they are but generates revenues from wealthy citizens by closing loopholes."

And he believes that such an idea would popular, telling NPR, "I would say that most Americans would like to see the tax code get rid of all the loopholes that exist there."

He's probably right. What most Americans surely want is fairness. They'd like to know that some taxpayers aren't granted the privilege of special breaks the rest of us aren't privy to. The highest-income households enjoy more than 40% of the benefits of all tax breaks taken every year, according to the Tax Policy Center.

However it is arrived at, the government needs to increase revenue and reduce spending.

Some economists and analysts advance the notion that a country can indefinitely run deficits without endangering its economic survival as long as those deficits remain below its rate of economic growth.

However, the U.S. has a debt that exceeds $16 trillion and is still growing. Though it will be impossible to ever fully repay that debt due to the nature of money itself, it is important to begin continually chipping away at the debt rather than adding to it. Otherwise, the bond market will eventually turn on the U.S., sending interest rates soaring.

The trouble for the U.S. is that we are in a sustained pattern of about 2% economic growth and it is difficult to foresee that changing over the next few years. Any sudden internal or external shocks (economic crisis in Europe or Japan, for example) could easily tip the U.S. into recession.

That's the concern with the fiscal cliff. According to the Congressional Budget Office, the looming combination of tax increases (the end of the payroll tax holiday and the Bush tax cuts) and legislated budget cuts will lead to a recession, shrinking the economy by 1.3% in the first half of 2013.

The upside is that the CBO also says the economy will then expand 2.3% in the second half. There's some pain upfront, but there's some relief in the end.

Congress and the nation are faced with a moment of truth. Though this combination of hikes and cuts will be painful, it is needed nonetheless. Congress needs to swallow this bitter medicine and take a leap off the fiscal cliff.

Yes, it will result in a recession next year, but the long term benefits will make it worthwhile. Congress has avoided these difficult decisions for far too long and to avoid them any further will result in an even worse predicament down the road.

The time for easy choices or good alternatives has long since passed.