Sunday, December 2, 2012

Fiscal Cliff - The Big Picture

What combination of tax increases and spending cuts should be used to reduce the deficit?  Who should make sacrifices?  Do we need to make significant reductions in the deficit right away or over time?  While it's tempting to get bogged down in the details, it's important to step back and see the big picture. The fiscal cliff came about over concerns about the budget deficit and national debt. However, from an economic point of view, the goal is not to balance the budget and/or reduce the national debt. Instead, the goal is to try to achieve strong and sustainable economic growth over time (which should increase the average standard of living and thus improve the lives of people). High deficits and debt are a threat to sustainable economic growth, whether through crowding out of investment (i.e., making it more difficult for business to purchase necessary equipment, structures, etc), crowding out of government programs or tax reductions (due to having the pay more interest on a growing debt), or risking a sovereign debt crisis. Thus, any policy designed to control the budget deficit should take into account how it affects economic growth over time.

Policies to reduce the budget deficit are likely to reduce economic growth in the near term, thus most economists suggest an approach that has a small effect initially, but is generally seen as resulting in significant deficit reduction over time. To summarize, the following are generally agreed to be elements of a successful package:
  • credible deficit reduction plan that has a larger impact in the medium to long run
  • does little harm or promotes long-run economic growth (i.e., does not discourage increases in human capital, physical capital, or technological development)
  • accounts for non-economic values (people may differ on these; they may include phasing in changes to programs like Social Security, Medicare, etc., since current retirees and those approaching retirement made plans based on the current system; also, there are issues of efficiency vs. equity, ...)
What changes need to be made?  Given the results of the 2012 election, it is generally agreed that increasing tax revenue will be part of any deal. In a previous post, I discussed one proposal to limit the amount of deductions to $50,000, that is estimated to be able to raise more than $700 billion over ten years, 80% of which comes from the top 1%.  On the spending side, virtually all budget experts and economists recognize the need to reduce the growth of spending on entitlements, since that's the fastest growing part of the budget (note: though the graphic below is from the Heritage Foundation, a conservative organization, the underlying data is from the Congressional Budget Office and President Obama's Office of Management and Budget).

Other programs can be changed as well, but tax changes and reducing the growth of entitlement spending are essential components of any credible deficit reduction plan. The question remains, will there be the political courage to make the tough decisions and the necessary compromises?