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“You telling lies thinking I can’t see…..I’m down (I’m really down)” Lennon/McCartney

June 18, 2012

The big news of the past month has been the trifecta of (1) The worsening European debt crisis and economies (2) US slowdown in job and GDP growth to a crawl and (3) the increasing realization of the upcoming “Fiscal Cliff”. The stock markets have not greeted this news well with the S&P 500 down more than 10% since its peak in April, though it has recovered some of late. Interestingly, the Fed is expected by some to begin a QE-3 (i.e.quantitative easing , likely involving additional money printing) but I wonder what positive effects it can possibly achieve even in the short run. (And as we know in the long run this is just further poisoning the value of the US dollar). Today, ironically enough, treasury bills and bonds are viewed by the world as the “safe haven” . This has led to extremely inflated treasury prices relative to even recent history. Yields are at all time record lows. So it is a little hard to see how more massive, money printing will do much good even in the near term.

The interesting political and economic question is what will Congress do regarding the “fiscal cliff” and more importantly, what should it do. It is my contention that NOBODY in Congress wants EITHER the tax increases or the specific spending cuts (even Republican deficit hawks don’t like the large amount of cuts to Defense) due to go into effect at the end of this year. While some observers fear a stalemate in which Congress takes no action and both the tax increases and automatic spending cuts occur, a more likely outcome is a last-minute Congressional delay in these policies so the 2012 status quo is extended to 2013. Both Rs and Ds can “save face” by claiming that they were unable to meet their party’s objectives (e.g. D’s repealing the Bush tax cuts on the “wealthiest few”, R’s targeting budget cuts so that Defense is not hit nearly as hard) because of the intransigence and lack of bipartisanship of the other party. However, both will make predictable announcements about plans to work on more serious long-term changes and reform NEXT YEAR. (just like the Cubs are likely to win it all NEXT YEAR).

OK so what should Congress do?

First, Congress needs recognize that one part of the “fiscal cliff”, the automatic spending cuts, will have only a relatively small, short-term impact on the economy, not the Armageddon that some have predicted. We are spending at a $3.6 trillion annual rate (vs our $2.7 trillion rate in 2007) . Is cutting this spending by a mere $100 billion really going to take the starch out of a $15 trillion economy? Clearly, the answer to this is NO, despite some of the political rhetoric you are already hearing. Sadly, the US Government is a bit like the alcoholic who admits he has a problem,  agrees to attend at least one AA meeting (i.e. our budget deal of last summer) and then, when someone points out that those meetings can be unpleasant, decides that maybe he’d rather not go.  These “automatic” cuts (about $1.3 trillion over the next 10 years) only get us about 10-20% of the way towards the ultimate cuts we will need in future spending, but if Congress can’t even abide by its own agreement to start this process, is there any chance we can actually tackle this problem? I believe we should NOT postpone these cuts.

Second, the other part of the fiscal cliff is five times more significant and includes $500 billion in new taxes, or expiration of tax cuts. $120 billion of the increase is from the social security payroll tax cuts which was to be a temporary “one year” (hah!) cut in taxes to help revive the economy. As expected, its political popularity (every worker benefits) has resulted in its extension thru 2012 and almost certainly 2013 as well. The largest part of the tax increase is the $300 billion from the expiration of the Bush-era tax cuts . This seems to be the most misunderstood part of the tax changes. Many including some in Congress seem to think that these were entirely to the benefit of the wealthy few, but in fact involve cuts in ALL the income tax brackets with the largest % cuts occurring in the lowest brackets (the bottom marginal tax rate of 15 percent was cut to 10 percent and the amount of income not subject to tax at all was increased significantly). In other words, there will be widespread pain associated with these tax increases. Given the relatively large short-term impact on the economy, and the fact that this Congress is NOT going to pass any meaningful reform this year, Congress should extend the current tax code thru 2013.

Unfortunately, the discussion of the fiscal cliff is a distraction or a sideshow. It is just another excuse to postpone the hard decisions off until well in the future. Instead, Congress needs to pass  a comprehensive,  three-pronged strategy that includes:

(1) Major Tax Reform– Blog readers will know that I prefer the “Fair Tax”, but even changing our code to a few marginal income tax rates with NO deductions is vastly preferable to what we have now. The most important part of this would be to make the tax code more efficient so it raises more revenues without hurting the economy. (See “Should 5 Percent Appear to Small …” Post in March)

(2) Targeted cuts in Federal Domestic Spending— This should include greater privatization and user fees for some services as well as elimination of some non-core government functions. —  (see my “Defusing the Debt Bomb….” Post in January) 

(3) Long run entitlement reform of Social Security and Medicare.–This is the most important area of all and one that I promise to post about soon. The explosion of these costs in the next 10 years could ruin our economy for a long time.

Congress needs to start working on this NOW, as opposed to postponing this still further into the future. This is probably just dreaming on my part, but hey that’s what blogging is all about! Otherwise, I guess “I’m really down.”

  1. William Hildeson permalink

    Great Post. My parents just retired and feel they’re paying too much in taxes yet are also taking both SS and Medicare. Ironic. I think that disconnect of reality is key to resolving number 3. Al Gore’s “lockbox” didn’t get much traction but it seems like a good idea.

  2. Reform taxes, reduce medicare and social security, and cut domestic spending? How about not spending another penny on extremely expensive wars that have done nothing but make the world a more dangerous place where American’s are universally despised? Why not halve defense spending for a start? And privitization in all quarters has been disastrous.

    • I agree about cutting defense spending and I believe I have said so in many of my previous blog posts as well as this one. I have never been particularly enamoured with the US spending money on foreign wars and it is clearly something we can’t afford anymore. However, even massive cuts in defense wont be nearly enough to make us fiscally solvent as a nation in the future.
      On the other hand, the “facts” behind privatization of some government services is that in virtually all examples that I have studied, the cost of the service has fallen as a direct result. “User fees” have a way of making people decide what they really want, and forcing the service provider to be very competitive with alternatives.
      We need an “all of the above” strategy along with tax revenue enhancement/reform and reductions in entitlement spending in order to have any hope in avoiding a US financial armageddon.

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