Wednesday, November 28, 2012

Over the Fiscal Cliff with Us!

The most sensible piece on the fiscal cliff I've seen is this perceptive analysis by Ed Dolan.  (Read it!)  He makes three points that are right on target.  I concur with all.

The fiscal cliff is an artifact of the bizarre and ridiculous fight in 2011 over the debt ceiling, as well as the complete failure by politicians of both parties to give serious attention to our long run budget problem, or even to speak coherently on taxation and spending issues.  Here are two of my own points:

1. In an important sense it is impossible to cut taxes while engaging in deficit spending.  One can only transform the way in which the spending is paid for.  If it is not via formal taxation, then it's either by borrowing or creating money.  In the case of borrowing, it's ultimately then paid by future taxes, or default, or monetizing the debt (and we're back to creating money).  That's why the "starve the beast" strategy never made any sense at all, and why the fight over the debt ceiling was absurd.  Buchanan and Wagner's term, "fiscal illusion," makes the point nicely.  And conversely you cannot increase taxes either -- tax increases are again a shifting of the tax burden among potential payers.  Arguments over taxes ought to be about minimizing the distortion and harm of taxes.  Arguments about the size of the budget should be about spending and the role of government.

2. Fixing the long term structural debt problem is crucial.  Serious analysis shows that the fundamental problems are entitlement programs and service on the debt.  There are a number of reasons to think CBO understates the seriousness of the problem; for one thing, the alternative fiscal scenario may well be optimistic.  And the fiscal gap -- the present value of the difference between projected spending and revenue -- is even greater.  But even the optimistic alternative fiscal scenario is dangerous.

What to do?  Pfffttt!  I suspect 100% of what Congress and the President are doing is political maneuvering for the next election.  Most of what I've read suggests that at the last minute Congress will cobble together another short term fix, e.g. extensions of the various temporary tax cuts and AMT relief.  I suppose so, this makes sense.  But how about this for an alternative fiscal scenario: Suppose the Democrats don't budge on the offer to extend the Bush tax cuts except for income earners over $250,000, and let us go over the cliff when Republicans refuse.  What then?  Well, besides a recession, I mean.  How about next they offer the following deal: a new set of "Bush" tax cuts applicable only to those earning under 250K, retroactive to 1 January.  It would be hard to imagine how Republicans could refuse, and also how they'd avoid taking public blame for the recession.  (BTW, I didn't think up with this strategy.  It was in an op-ed I read and have now misplaced, in NYT or WaPo as I recall.)

The GOP has painted itself into a corner by adopting indefensible positions on taxation -- insisting, for example, that cuts in marginal tax rates necessarily generate economic growth, that tax cuts "pay for themselves," and similar nonsense.  Making full use of this will likely require more sense and discipline from the Democrats than they are capable of, so I suppose we'll indeed see another brilliant "fix" that delays things another year or two.

Dr. Steele,

I am largely in agreement with your points here, but not Dolan’s. But first, I will make a point of my own. Cutting military spending dramatically is also indispensable to solving the US fiscal situation in the long term. Most US military spending is sheer waste, as a twofold and even a threefold reduction would still leave the US far outpacing its nearest competitors (Russia and China) in terms of absolute military spending. Unfortunately, military spending has become a political bragging tool, where civilian politicians who know nothing of military affairs often propose to spend more than the military itself recommends.

Now, on to your analysis. I agree that it is not necessarily the case that tax cuts “pay for themselves.” To simplify the analysis, this depends on which side of the Laffer Curve the status quo is on. It is entirely possible that the current tax rates are to the left of the “optimum” on the Laffer Curve. That being said, I am still in support of tax reductions wherever they can be accomplished, provided that spending declines more than taxes are reduced (thereby reducing the deficit). It is true that cutting taxes without cutting spending can ultimately lead only to a greater interest burden (which will be paid for through future taxes) and, ultimately, inflation or default. In that situation, tax cuts do not result in long-term economic growth. However, if taxes are reduced in a manner that does not increase deficits, then economic growth will be an outcome, simply because people are allowed to keep more of their own money and use it in a manner that enhances their subjective utility.

More in the next post.
Dolan’s analysis, on the other hand, is not libertarian or liberty-friendly at all. He makes arguments as to why it cannot possibly work to have federal spending be even as low as 20% of GDP. Anyone who considers the very possibility of an “unrealistically low level of spending” to exist, given the extravagance and wastefulness of federal spending in the status quo, has clearly not been paying attention to recent events.

Regarding Dolan’s second point on the tax structure, my position is that only incremental tax reductions should be favored in any area. (In other words, ideally, I favor each tax-policy change being a Pareto-efficient move.) This means that, even if the current tax structure is uneven and results in certain interests “gaming the system,” the solution should be to reduce taxes for those who are not so privileged, so as to eliminate the “gaming” incentives. For instance, instead of accepting Dolan’s recommendation to tax capital gains and dividends as ordinary income, the tax on ordinary income should be reduced to the level of tax on dividends and capital gains (15% for personal taxpayers, I believe) – except in situations where the tax on ordinary income is already lower (i.e., for the lowest marginal-income brackets). Instead of wholly eliminating deductions on charitable donations and mortgage interest, the standard deduction could be increased so that everyone receives an equivalent benefit.

That being said, I do not intend to say that there cannot be good structural reform that eliminates certain special privileges, as long as the overall effect of the reform is to so dramatically lower tax burdens for most people, as to render the closing of the “loopholes” tolerable for the purposes of a political compromise. This is especially true if the interests benefiting from the “loopholes” are the otherwise subsidized, bailed-out, politically connected types who would not have thrived in a free market.

Dolan argues that the “austerity bomb” could throw the economy into recession. Perhaps it might, by official measures. However, such a recession might be the necessary correction described in Austrian business-cycle theory. It has been put off somewhat by expansionist monetary policy and fiscal deficit-spending, but the longer it continues to be put off, the worse the eventual reckoning will be. We might as well get it over with sooner rather than later.

This brings me to my final point: I actually want the “fiscal cliff” to happen. (I do not like or support the tax increases, but it would be politically easier to undo those for the majority of people; even Obama has shown willingness to do this for income levels below $250,000.) At no other time in the near future will there be an opportunity to curtail military spending to the extent that is being proposed here.
Moreover, in terms of domestic spending, the “fiscal cliff” confronts federal politicians with reductions that their ordinary modus operandi would never permit. The “fiscal cliff” was intended to be a “stick” incentive to get the federal politicians to agree on a more politically palatable solution last year; it was specifically designed to scare them into acting – so it has to be contrary to the usual perverse incentives dominating their decision-making. If the “fiscal cliff” is averted, then any such “stick” incentives would lose credibility. Everyone will understand that, no matter what grim deterrent the federal politicians place to their inability to achieve a sensible fiscal agreement, any deadlock and continuation of the status quo will ultimately result in the “scary alternative” being undone – so it will cease to be a deterrent. If the “fiscal cliff” fails, then I predict that no substantial fiscal reforms will be achievable at least until this entire episode in American politics recedes from the memories of all but a few.
Dr. Steele,

I have also published a new video on the subject of the “fiscal cliff” – which you may be interested in seeing.

Very thoughtful comments, Gennady. I mostly agree with you, so let me focus on my disagreements (hah!)

I interpret Dolan differently. I think he's making a factual point -- that there's no political constituency for the kinds of cuts Republican policy suggests, probably not even among republicans. As he points out:

It would be worse than pointless to accept a deal that, explicitly or implicitly, imposes an unrealistically low spending cap as the price for defusing the austerity bomb. Any such deal would just have to be redone in a few years, by which time the budget would be in worse shape than it is now.

Consider that we could in principle end the long run debt problem by simply abolishing Medicare, Medicaid, and Social Security immediately. But the negative consequences for a large number of Americans would generate political backlash, and we'd soon have the the programs restored (and a majority even more strongly convinced that "free market" solutions don't work).

The same kind of argument holds for less extreme caps, and that's Dolan's point, I think. It's political realism, not antagonism towards liberty.

In this matter, the development of non-state alternatives is more important. so long as state provision of some service seems the only practical means of getting it, proposals for reducing or abolishing state intervention in that area won't be very successful.

I'm unsure whether I understand your point that "only incremental tax reductions should be favored in any area." Do you mean taxes (or perhaps rates?) should never be changed, unless downwards? If so, I think it's problematic. Two examples:

1. Suppose a subsidy (e.g. for ethanol production) is structured as a tax credit. Then abolishing this amounts to increasing taxes, and presumably violates you position. (Grover Norquist actually opposed abolition for this reason.)

2. Unless one argues that the optimal tax and tax rate is zero, there must be some positive rate(s) or total revenue that are superior. The "zero is optimal" position is close to an anarchism (although arguably not the same). Anarchism is interesting and shouldn't be dismissed, but it has not at all been shown that it would be superior to the minimal state or even the status quo. It is also not a reasonable prescription for immediate fiscal problems.

I particularly like your observation that for any Congressional commitment device to have teeth, the teeth must bite on occasion. I tend to agree on this one -- let them snap away!

But I also suspect that the Democrats will then return with their original deal, the republicans will accept -- since now it is framed as a tax cut for the mid-range income instead of a tax increase for the high income. And the whole thing will have been a charade, with a recession added to the mix. I don't expect such a recession to include Austrian-style capital restructuring. More likely is contagion for the rest of the world giving further economic and political turmoil.

That said, you may well be right that it is as good an outcome as we're likely to get.

One other very important point -- you're exactly right about military spending -- this is likely the only way to get it cut, and this is much needed. Even a hawk ought to find cuts acceptable -- I recently heard a defense analyst explain how bloated budgets have allowed the officer corps to substitute materiel for competence and has actually weakened the military is some respects.

Our enormous military spending is generated more by rent-seeking than by any particular strategic vision, and the fiscal cliff is one way this rent-seeking could be blocked.
Dr. Steele,

Thank you for your reply. It is clear that we agree on much here –the status of the “fiscal cliff” as the best among the unsavory fiscal alternatives at present, the need to reduce military spending dramatically from current levels, and the ultimate desirability of non-governmental methods of providing various services that are currently associated almost exclusively with the welfare state in many people’s minds.

I do think, though, there is a difference between political realism and status-quo bias, and that Dolan exhibits the latter. Political realism would acknowledge that the immediate abolition of Social Security, Medicare, and Medicaid is not feasible. My view is that a lot of innocent people have been forced to contribute into these systems and led to rely on them to pay them back – an arrangement that could even be described as quasi-contractual, except that it involves elements of coercion, massive unfunded liabilities, and intergenerational transfers of wealth. I do not think there should be a situation where the federal government would need to default on its existing promises (properly defined) under these programs – but introducing an element of choice (e.g., the ability of younger people to opt out of these systems), while funding the existing obligations through cuts in discretionary spending, would be politically realistic while still doing something to solve the inherent and accumulating problems in these programs. (The Chilean solution from the early 1980s comes to mind here.) Dolan, unfortunately, does not really consider any serious reforms to the design and incentives of the programs that have contributed to the present fiscal mess.

Regarding taxation, my view is indeed that one should not support any increases in tax rates on any individual. This view is not an anarchist one (it even allows for increases in total government revenue – just not through increasing tax rates), but rather one favoring a minimal (or, at least, less overarching) government that is (wholly or largely) supported by non-tax revenues. You are familiar, I think, with my concept of investmentocracy as a conceptual vision for a system of funding government which does not rely on taxation. Other funding options would include direct user fees, voluntary donations, and interest on an accumulated surplus. Of course, an immediate transition to a tax-free system is not possible; it would take time and dramatic reductions in spending and in the commonly understood roles of government. That being said, I always support incremental movements in the right direction – which means lower taxes but even lower spending (and we agree, I think, that the former cannot be sustainable without the latter). I never support incremental movements away from the minimal-tax concept. (In practice, I can live with such developments as an individual – not that I have much influence over the matter – but I cannot endorse them or consider them desirable in any manner. I rather consider them to be perhaps unavoidable byproducts of today’s broken political process.)

As a “reasonable prescription for immediate fiscal problems” – I would recommend an x-to-1 matching principle for spending reductions versus tax reductions (where x could equal some number greater than 1 – perhaps even 3 or 4). In this way, spending, taxes, and the deficit could be reduced simultaneously, while the federal government’s incentive to monetize the debt would also decline. I think that cuts in military spending would be the most effective way to achieve this without causing economic hardship to innocent people.

I am largely in agreement with you, except regarding Dolan. I'm fairly skeptical that our current political leaders are capable of tackling this problem. This morning I heard a Republican Congressman agree that the debt is a long run problem, not short run, but that Congress can only focus on immediate crises and hence the emphasis on short run. I think he's right. Given that, the fiscal cliff is more attractive than ever.

Re Dolan; I have read a fair amount of his other writings. In the context of these I think he's a realist, rather than a friend of status quo.
Post a Comment

<< Home

This page is powered by Blogger. Isn't yours?