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

Posted in: Government

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.