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A Mismatch Between Tax Politics and Deficit Rhetoric: A Very Bad Tax Deal Is Passed by Politicians Who Do Not Understand the Economics of Deficits

The best thing that can be said about the new federal tax law that was passed over the New Year’s holiday is that its passage might remove the phrase “fiscal cliff” from our popular lexicon. There was never anything like a cliff facing the nation, and most people (including most politicians in Washington) did not even understand that what we were trying to avoid was too much deficit reduction, not too little.  Yet they chattered incessantly about the cliff, without ever truly understanding what they were talking about.

Even without that inapt metaphor, however, we still face a future in which poorly informed politicians and commentators will pontificate about the future of mankind, making bad policy decisions because they misunderstand the economics of spending and deficits.  Both Republicans and Democrats will continue to aver that the federal government spends and borrows too much, and they will then decide how to administer “strong medicine” to the American people as a supposed cure.  It need not be this way.

The last-minute agreement between Republicans and The White House is bad in many ways (and good in very few ways).  In this column, I will first briefly describe the deal that was struck, and then explain why it is mostly a bad deal, even on the standard terms of political discussion in Washington.

More importantly, I will then explain why the big picture is very, very different from the one that was painted by Beltway insiders in the run-up to the deal.  The U.S. federal government’s long-term budget situation is not at all what we have been led to believe, and President Obama and the Democrats are inflicting needless pain on vulnerable people, in pursuit of a false vision of fiscal prudence.

The Basics of the New Year’s Eve Deal: Permanent Tax Cuts for Wealthy People, and Only Temporary Relief for the Most Vulnerable Americans

The most important fact to remember about the tax aspects of the so-called cliff is that they were set in motion in 2001, when Congress passed the first of two major tax-cut bills under President George W. Bush.  With those tax laws set to expire at the end of 2010, President Obama agreed to extend all of the Bush-era cuts through December 31, 2012.  Without further action, all tax rates would have risen back to pre-2001 levels two days ago, as we moved into 2013.

The new law, which President Obama signed yesterday, makes almost all of the Bush tax cuts permanent.  All income tax rates for couples earning below $450,000 in adjusted gross income ($400,000 for singles) were made permanent, while the rate on those upper earners rose from 35% to the Clinton-era rate of 39.6%.  A couple with income of, say, $500,000, would thus face a higher tax rate on the last $50,000 of their income (because the first $450,000 would be taxed at the permanent lower rates).

In addition, the estate tax was set to revert to its 2000 form, with a 55% rate on the amount of each taxable estate (which is the amount remaining after charitable deductions and other expenses are taken out) above a one million dollar exemption.  Under the new law, however, the estate tax has now been permanently set at a 40% rate on taxable amounts in excess of $5 million dollars ($10 million for couples), with the exemption amount indexed for inflation.

These are rather dramatic concessions for the President to have made, in light of the fact that he campaigned on the promise to allow tax rates to rise for couples earning over $250,000, and for the estate tax to be set at a 45% rate on a still-enormous exemption amount of $7 million per couple.

What did the White House get in return for these major concessions?  A one-year extension of benefits for the long-term unemployed, and five-year extensions of various tax credits for low-income workers.  While these are all laudable outcomes, it is the temporary-versus-permanent aspect of the changes that matters the most.

The only way that the tax increase on high-income earners came into being at all—the only way—was that the lower rates for everyone had been set to expire, giving the President negotiating power that he would otherwise have lacked.  There is simply no way that Republicans would have voted to increase the tax rates on higher-income people without the threat that inaction would have raised taxes on even more people, thus putting political pressure on Republicans to allow at least some increases in higher-income tax liabilities.

Even so, the White House could not even stand firm enough to extend the 2% payroll-tax reduction that was also set to expire at midnight on New Year’s Eve.  That means that a couple earning $100,000 will pay $2000 more in taxes in 2013 than they did in 2012 or 2011—which is actually slightly more than the income tax increase for a couple with $500,000 in income.

In short, even though there were some things that President Obama could point to as “concessions” from the Republicans, he now moves forward without the important leverage that he once possessed.  Yet he allowed regressive tax changes to come into force immediately, all the while setting up future deadlines as to which he has left Democrats with no negotiating power.

If Both Sides Are Disappointed, Does That Make This a Good Deal?  More False Equivalence in the Media’s Coverage of the Politics of Taxes

Because the new tax law can accurately be described as a compromise—with, literally, both sides giving up something that matters to them—it is tempting to describe the deal as good politics.  And politicians and pundits have, indeed, been quick to say that this deal shows that the art of compromise is not dead.

A corollary to that simplistic mindset has it that those who are disappointed on both sides of the aisle must be viewed as equally intransigent and equally unreasonable, and that the country should thus be happy that neither side’s extremists got their way.  On this theme, The New York Times ran two news articles (available here and here) in which reporters described unhappiness among Republicans and Democrats alike, regarding the outcome of the negotiations.

If both sides’ true believers are unhappy, then we must have found the “sweet spot” in the middle, right?  Hardly.  As the first Times article linked above puts it: “Just a few years ago, the tax deal pushed through Congress on Tuesday would have been a Republican fiscal fantasy, a sweeping bill that locks in virtually all of the Bush-era tax cuts, exempts almost all estates from taxation, and enshrines the former president’s credo that dividends and capital gains should be taxed equally and gently.”  The current generation of Republican extremists, however, views the deal as a betrayal.

Democrats, whom the Times described in one headline as “grousing” about the new law, are supposedly in the same position, of not being willing to take yes for an answer, either.  “While Mr. Obama got most of what he sought in the agreement, he found himself under withering criticism from some in his liberal base who accused him of caving in to Republicans by not taxing the rich more.”

It is odd, indeed, to describe the President as having gotten “most of what he sought,” after two election campaigns in which he set a (rather high) threshold of $250,000 for tax increases, only to agree upon a level that is almost double that amount—at a time when he held all the cards.

And even if President Obama could accurately be described as getting most of what he wanted, what he wanted was a fundamentally conservative package.  Moreover, he did not get the Republicans to agree to increase the debt ceiling, which is (as I argued in a Verdict column last month) the most dangerous aspect of the Republicans’ radical strategies.

Also, the spending cuts that were set to take effect on January 1st have merely been pushed back by two months, with the President again leaving himself with no basis to negotiate when the extra time lapses.  That deadline will quickly be followed by the expiration of the temporary budget under which the federal government can operate through March 27, with a government shutdown a real possibility at that time.

Is All This Pain Even Necessary?  The Long-Term Budget Picture Looks Much Better Than Most People Think

Increasing taxes on the wealthy is an important policy goal, no matter what the situation with the federal budget may be.  As the economist Joseph Stiglitz argues, the level of inequality that we have reached in this country not only is immoral, but also actually harms the economy, reducing growth and making it harder to employ workers in modern jobs.

Therefore, even though the President and his Democratic colleagues have been treating minimal tax increases on the wealthy as part of an effort to bring down long-term deficits, the important reality is that income redistribution is both morally and practically essential.

It is, however, damaging for the Democrats to parrot Republicans’ anti-government talking points about spending and deficits, because their doing so makes it more likely that the Democrats will soon agree to unnecessary cuts in spending on Social Security, Medicare, and other government programs that allow people (especially the elderly) to live in dignity.

To be clear, there was never a plausible case to be made that the “big deficits” of the Obama era have been excessive, in any meaningful sense.  Given the state of the economy, we should have expected short-term deficits to rise.  The only question was whether there will be a sustained series of inordinately large deficits in the future that should give us pause.

Some economists, starting in the 1990’s, and continuing into this century, claimed to be able to foresee just such a series of crippling deficits, occurring decades in the future.  The reality, however, is that there was never an airtight case proving that the federal government faced a long-term budget catastrophe.

I am among those economists and other analysts who have been pointing out for years that the only aspect of the long-term budget picture that is truly troubling is the projections for increased health-care spending.  Even the forecasts that showed the most damaging long-term trends, in fact, found that Social Security could easily be stabilized, and that every area of federal spending other than health care was already in long-term balance.  Again, the only long-term concern was based entirely on health-care spending.

Although those forecasts of rising health-care inflation are genuinely scary, they are also based on some rather questionable assumptions.  Essentially, the budget pessimists assumed that health-care costs, especially for Medicare and Medicaid, would rise for the next 75 years as quickly as they have for the last generation or so.

If that were to happen, it would destroy not only the federal budget, but also the entire economy.  Health-care inflation would, therefore, have to slow down at some point.  We simply did not know when, and we did not know how much damage would be done in the meantime.

As it happens, new evidence suggests that those pessimistic assumptions might already be turning out to be wrong.  Recent data show that Medicare’s rate of cost inflation has dropped rather dramatically over the last few years, and that the decrease started before the most recent recession.  In other words, we might already have begun our inevitable adjustment toward lower, sustainable health-care inflation.

One might argue that the prudent thing to do now is to assume that this is a temporary reprieve, and that we should go ahead and slash Medicare (and every other government program that we can find) now, just in case costs rise in the future.  But this would be both foolish and cruel.  Real people will be harmed by current cuts.  Making them suffer on the basis of highly uncertain long-term forecasts would be truly inhumane.

The only reason that one might wish to ignore the reality—and the inherent uncertainty—of our long-term budget forecasts is if one has already decided that Medicare and Social Security should be reduced or eliminated.  Many Republicans openly admit that they would like to destroy our most successful social programs.  President Obama and the Democrats should not assist them in their attempt.  Dropping the apocalyptic budget rhetoric would be a good place to start.

Neil H. BuchananNeil H. Buchanan, a Justia columnist, is an economist and legal scholar, a Professor of Law at The George Washington University, and a Senior Fellow at the Taxation Law and Policy Research Institute, Monash University (Melbourne, Australia). He blogs at DorfonLaw.org, and he is the author of The Debt Ceiling Disasters: How the Republicans Created an Unnecessary Constitutional Crisis and How the Democrats Can Fight Back.
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  • Max Herr

    I had high hopes that this would be an accurate assessment of the economic problems facing America. But, alas, it is simply more of the socialist rhetoric that threatens the American empire, as the summation states: “Many Republicans openly admit that they would like to destroy our most successful social programs. President Obama and the Democrats should not assist them in their attempt.” The tipoff, however could be seen earlier, when Buchanan writes, “the important reality is that income redistribution is both morally and practically essential.” ONLY A CARD-CARRYING SOCIALIST could make that statement, which is the death knell for America as we have known it for almost two-and-a-half centuries.

    America was not founded on such poppycock! The founders envisioned a place where each person could succeed on his own merits, free of the fetters of social economies that gave the wealthy — the landowners and merchants — the voice and power of government. I will agree, in concept, that much of that has come home to roost in America today, not because it is a natural phenomenon, but because it is the natural outcome of social entitlement programs that lay the foundation for the “poor me” class warfare between those who achieve success by claiming their entitlements instead of working to claim their own prosperity in spite of government.

    There are several other socialist flaws in Buchanan’s article, such as, “Even so, the White House could not even stand firm enough to extend the 2% payroll-tax reduction that was also set to expire,” “[Obama] did not get the Republicans to agree to increase the debt ceiling, which is (as I argued in a Verdict column last month) the most dangerous aspect of the Republicans’ radical strategies,” and, the most flawed of them all, “Social Security could easily be stabilized.” Let me address each one.

    First, only employers pay “payroll taxes,” employees do not. There has never been a reduction in the payroll tax — employers have, in the past two years, paid their full share of the 7.65% FICA/Medicare contributions, not to mention their full FUTA assessments. People who actually work and earn money received a temporary reduction in their Social Security, but not Medicare, contributions, but most fail to realize that also means a slight reduction in their future retirement benefit amount (assuming it will be there when they get there). That’s not the PAYROLL TAX, that’s simply the employee’s share of the total 15.3% FICA contribution, which was reduced in 2011 and 2012 to 13.3%.

    Second, why do we need an increase in the debt ceiling? It’s not so that government can keep operating, it’s only so we can continue making payments on the debt we already have. Almost all of the current socialist entitlements could be paid for many times over if it were not for the fact that we are paying enormous amounts of interest on the existing $16.425 Trillion public debt — $16,425,000,000,000 for those who can envision it — most of it racked up since the 1980s when Reagan began spending far more than the Treasury was collecting in taxes. Perhaps it would be best if America were to march into bankruptcy court and beg for forgiveness. Wipe out all the debt — owed to our own citizens, corporations, and China and the rest of the world — end all the public employee pensions as they are currently constituted, and reformulate a spending plan within our means.

    Corporations do this, households do it, some states have even managed to do it. Why must the federal government see itself as the savior of the world and the nonworkers in America? When Marx’s and Engels’ philosophy entreated the workers of the world to unite, it was not for the purpose of having them stop working and claim the resources of the government treasuries. But that’s the philosophy of socialism in America today — who needs to work when the government will simply redistribute the wealth? If it were not for the wealthy, there would be no America today . . . which is why there will be no America in the future — if being wealthy is elevated to the status of the eighth mortal sin.

    Finally, there is no way to “stabilize” Social Security and Medicare as they currently exist. Despite the “statistics” that show the “rate” of spending increase is declining, we are still spending more today on those programs than we did yesterday, and those programs currently have a combined $122 Trillion unfunded liability, which is rising at the rate of $1,000,000 every ten seconds — more than $3 Trillion every year. Go ahead — slow the spending rate by 50% and tell us what that means. It means only that the unfunded liability will only grow by $1.6 Trillion instead. The unfunded liability will not decline. No politician, no economist is willing to admit that. Instead, the battle cry is, “I am committed to strengthening Social Security and Medicare.”

    There is not enough money in America, even if all the wealth/savings and personal possessions of every person in America were confiscated and beaten into plowshares, to overcome that future liability. You cannot beat a dead horse back to life. As one CEO I know once said at a forum on Social Security 6 or 7 years ago, when asked if there were any way to fix Social Security, he replied, “Madam, when the horse is dead, and lying on the ground, it’s time to dismount.” Those who know the reality, refuse to do so.

    So, yes, “A Mismatch Between Tax Politics and Deficit Rhetoric: A Very Bad Tax Deal Is Passed by Politicians Who Do Not Understand the Economics of Deficits” was the 100% correct assessment of the fiasco facing America. The actual assessment made by Buchanan, unfortunately, is 100% incorrect. So not much has changed.

    The Socialists are certainly unhappy. Despite “holding all the cards” they fail to have the collective strength to bring about the change they desire. The Republicans, who spent money in the 2001-2008 Bush years like a drunken sailor on shore leave, and who failed to make the Bush tax cuts permanent when they had the chance ten years ago, continue to muck things up to this day.

    Does anyone care that the United States of America has not had an official budget in nearly four years? We continue to act like the sailors who carry all their spending money in their socks (because a sailor’s trousers have no pockets). You cannot account for what you don’t have left at the end of the day because you have no starting point against which to measure your spending.

    Until America stops spending more than its actual resources, the future of America is rather dim.

  • http://www.facebook.com/jmichaelh2 J Michael Harrison

    Spot on. We have to start accounting for the effects of inequality growth. Here is my

    similar post from 2 days ago:

    http://acivilamericandebate.com/2013/01/01/falling-off-the-inequality-cliff/

    Someone please get Stiglitz more air time, and help Paul Krugman get past his long-held view that inequality is just a “political” problem. The politicians, and nearly everyone else, fail to understand the economics of inequality.

    • Max Herr

      Rave on all you care to about “inequality” (what is inequality growth?). The only ones who carry that mantle are the union employees who ride on the backs of taxpayers, and those who refuse to work, and are looking for the federal dole at every turn. In a capitalist society, there are those who create the jobs and those who work for them. It’s not a feudal system, because anyone can create their own prosperity . . . if they choose to. So, I guess the next thing “Guest” will want is two or three months of paid vacation because there is so much “stress” at work, like his lazy European socialist counterparts who have wrecked the European economy, resulting 75% tax rates.

      Wny bother to work when the government takes home more than you do? High income and payroll taxes are the single biggest encouragers of unemployment. Not the fact that businesses are laying people off.

  • http://www.facebook.com/jmichaelh2 J Michael Harrison

    Excellent analysis. Our understanding of the effect of inequality on growth, budgets, and national debt simply must improve. The increased revenues from the top are not nearly enough to stop the inequality decline, so the economy will just keep declining.

    There’s much need to follow up on Stiglitz’s perspective. (See “Falling Off the Inequality Cliff” http://acivilamericandebate.com/2013/01/01/falling-off-the-inequality-cliff/.)

    • Max Herr

      “the effect of inequality on growth” . . . “The increased revenues from the top are not nearly enough”

      Now there’s an oxymoron . . . or maybe just a moron speaking. Harrison is saying: the wealthy are not wealthy enough to redistribute their wealth and impact those at the bottom of his monetary chain? If that’s true, then there is no “inequality” on growth.

      What there is is an enormous base of lazy folks who expect the government to provide for their every need. Here’s what I’d be willing to allow the federal government do for them: purchase one-way tickets to any European nation of their choosing, revoke their American citizenship, and let them see if they can really do better in a genuinely socialist economy.

      Capitalism works . . . for those who work.

      You socialists have successfully been brainwashed by your socialist elementary, secondary, and post-secondary teachers.to believe that capitalism is evil. But take a look around . . . what socialist economy has the relative strength of the US economy?

      The problem is that you socialists are wrecking the American economy with your ever-increasing reliance on entitlements. Listen to Madame Pelosi — the socialist spokehole for the House Democrats — she is unwilling to take a look at any entitlement program with an eye to reduction. All she wants is more “revenue”.

      It doesn’t take much effort to discover that we once had a 90% top income tax rate in America. Those “happy days are [almost] here again.”

  • cncsawman

    Great post. Safe to say you won’t be appearing anytime soon with the “Morning Joe” millionaire deficit scolds advocating “shared sacrifice”. Locking us into tax revenues of less than 18% of GDP puts the New Deal on the chopping block, just where the DLC Dems wanted it on order to burnish their seriousness.

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