September 15, 2014

A Good Start

Signals from the first post-election budget meeting between the President and congressional leaders, which took place at the White House on Friday, were very good.

Congressional leaders of both parties appeared together after the meeting. There were no lines in the sand, no threats, and no impugning each other’s motives.

Beyond the low bar of politeness, President Obama and his guests appeared to be focused on the right priority -- achieving a long-term fiscal plan and not just a quick fix to the immediate pressure of the “fiscal cliff.”  

They spoke of a two-step process with a down payment on deficit reduction this year while putting together a framework for a long-term deal to be enacted next year along with a credible back-up mechanism -- more credible than a new cliff -- in case Congress fails to act. That basic approach has been recommended by many outside observers, including The Concord Coalition.  

Topping off the pre-Thanksgiving cheer was that a consensus seems to have been reached on the fundamental point that everything must be on the table, including revenues and entitlement spending.

We're still far from a long-term “grand bargain,” let alone a way around the fiscal cliff, but this is an essential starting point for fruitful negotiations.

Whether the promising tone of this start can be maintained through the tough negotiations ahead depends on whether these leaders are truly prepared to make some compromises that will be hard for their respective party bases to swallow. It also depends on their ability to stay focused on the big picture and not get derailed by disputes over individual policies that have more political significance than economic consequence.

One such issue is whether to let the top two marginal income tax rates revert to their pre-2001 level at the end of the year. President Obama says yes. Republicans disagree.

It’s a legitimate issue. However, the extent to which the upper income tax cuts have dominated the fiscal policy debate over the past decade is vastly disproportionate to their deficit effect, and certainly to their effect on economic growth.

The expiring 2001 and 2003 income tax cuts, and associated alternative minimum tax relief provisions, are the most significant portion of the fiscal cliff, accounting for $225 billion of the $487 billion in deficit reduction scheduled to take place between now and the end of Fiscal Year 2013. Extending them for most taxpayers except those in the top two rate brackets, as the President proposes, would lower this cost by just $42 billion. As for the economic effect, it’s hard to believe that the economy will sink or swim depending upon whether the top brackets stay where they are or increase by a few percentage points.

The election results, as well as basic math, indicate that higher taxes on the wealthy will eventually be part of the solution. On the other hand, attaching too much importance to this one issue now diverts attention from the broader tax reform debate that should take place within the context of a comprehensive negotiation that also includes entitlement reform.

If policymakers are contemplating a two-step process, how much the wealthy pay in 2013 for purposes of dealing with the fiscal cliff (step one – the down payment) should be easy to compromise. It should not stand in the way of a deal on a more permanent solution which requires more time to be negotiated (step two – the grand bargain).

A compromise on this politically charged issue would free them up to then figure out the proper glide path for discretionary spending in the short term along with securing a process by which more substantive progress on a long-term budget deal can be made in the next year.

To deal with the fiscal cliff, Congress could extend the current rates for another year while a long-term restructuring of the tax code is worked out (as Republicans want), but enact a temporary measure to increase revenues from the top income earners (as Democrats want). One way to do this would be to impose a one-year surtax on incomes above a certain threshold -- such as $500,000 or $1 million. Another would be to impose a one-year cap on deductions so that upper-income households would end up owing more taxes.  

Alternatively, Republicans and Democrats could resort to a traditional technique and simply split the difference on the top rate by temporarily setting it at 37 percent –- between the current 35 percent and the pre-2001 39.6 percent.

Either way should achieve enough revenue to postpone the cliff while negotiating a longer term structure for the tax code. Those negotiations could then proceed in a logical way -- figure out long-term revenue needs, increase efficiency by pushing base-broadening to its political limits, then set the tax rates at levels necessary to achieve the needed revenue which may well prove to be higher than today's rates. The point, however, is that this decision should be made in the context of a comprehensive deficit fix rather than as an opening premise.

As an old saying goes, “It’s not where you start; it’s where you finish.”