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The broader long-term implications of the election should be apparent after the fiscal cliff is resolved. Whatever the outcome, it will not be the most important piece of economic legislation over the next two years — or at least it better not be — but the tenor of President Obama’s negotiations during the next month will signal how — or whether — tax reform will proceed, as well as whether we will deal with entitlement reform during his administration. 1, The President holds all the cards in the fiscal cliff negotiations. But he can pocket some if he so chooses. If the president and Congress do nothing, tax rates go up, so Republicans can’t be content with the status quo. Most people admit (albeit grudgingly) that the president promised to raise taxes on upper-income earners and has some mandate to do so. If the president were to fall back to the Reid-Pelosi proposal from the summer and agree to their compromise of increasing taxes only on people making over $1 million, it would be hard for Republicans to oppose this without receiving the entire blame for sending us over the cliff on January 1. Blame for the ensuing slowdown in growth would likely be assigned to the GOP as well. During his press conference on Wednesday, the president appeared to reject the Reid-Pelosi option, although his press secretary had informed reporters the previous day that such an alternative was being seriously considered. So the president’s statement at his press conference — in which he pledged his fealty to increasing tax rates on all earners above $250,000 — should be seen merely as his opening bid. House Speaker John Boehner signaled support for increasing the revenue we collect from the wealthy, but prefers to raise the revenue by curtailing tax breaks. This could take different forms, including perhaps limiting the amount in deductions a taxpayer can take (a Romney proposal) or capping deductions at 28%. The latter idea is a proposal by Martin Feldstein, the chair of the Council of Economic Advisers under President Reagan, and is one that has been embraced by Jason Furman, Obama’s deputy director of the National Economic Council. It would be a magnanimous gesture if President Obama were to tell Reid and Pelosi to accept a plan limiting tax breaks (generating some level of tax revenue between the $80 billion per annum projected from increasing rates on earners over $250k and the $20 billion per year projected from increasing rates on earners over $1 million). Such a gesture would set the stage for real negotiations over fundamental tax and entitlement reform in the next two years. Raising the limit on which earnings are assessed for payroll taxes (a Democratic desire) isn’t particularly progressive (it hits middle-income earners on a proportional basis much more than upper-income earners) and is not necessary, either. Should the president decide to allow us to fall over the fiscal cliff, he will surely win political points, as the recalcitrant Republicans will be blamed for the impasse, and probably correctly. But doing so will gain the Democrats little politically (will the 2014 voters hearken all the way back to December 2012 when deciding whom to vote for?) and it will continue the same poisoned atmosphere on Capitol Hill, where short-term political points are more important than real success. 2. So the resolution of the fiscal cliff matters not so much because its outcome will impact the economy but rather because it will indicate whether more important reforms can happen. Tax reform cannot happen unless it is enthusiastically supported by the White House, which has heretofore strenuously avoided doing so. President Obama is the only person who can drag along Democratic Senators and Congressmen to do some kind of entitlement reform; will he make the effort? He will try: It is hard to dispute that it is the most important fiscal issue facing us, and if he wants to have a real legacy he has to begin there. Combining entitlement reform with tax reform makes sense because the President can make Republicans sacrifice by agreeing to a reform that generates more tax revenue in exchange for Democrats agreeing to Medicare and Social Security reform. 3. What would be the broad confines of a mega deal on entitlement and tax reform? Republicans prefer that tax reform be done by eliminating deductions, as Mitt Romney pointed out, however vaguely. The ultimate deal has two parts: What deductions do we eliminate, and how much of the revenue do we use to keep rates low versus how much do we use to pay down the national debt? While the second bargaining point is tractable, the first one is a lot more unstable. Eliminating deductions will anger a lot of people and it will be very easy for a small group of people to blow this up. For example, CA/NY/NJ members will scream when someone proposes scaling back deductions for mortgage interest and for state and local taxes, not to mention the various lobbying entities with vested interests. Others will cry foul over cuts that would adversely affect their constituencies. On entitlement reform, Republicans want to lower benefits and (at least in regards to Medicare) do more to constrain costs, while Democrats (to the extent they acknowledge a problem) want to increase taxes on upper-income earners. Solving Social Security is relatively easy. First, we index the retirement age to gains in longevity (which is going up rapidly). Next, we increase the inherent progressivity of an already progressive system by indexing initial benefits for high-income earners while leaving people at the bottom alone. Finally, we tweak inflation indices that cause continuing benefits to go up faster than inflation. While Social Security may be straightforward to solve (at least arithmetically), the Medicare solution is most definitely NOT easy. Raising the eligibility age and slowing health-care inflation have to be a part of any reform. The latter is easier said than done. The president’s demagoguery on eliminating the tax break for employer-provided health insurance obviated from political consideration the most basic way to do so. As it currently stands, the Affordable Care Act slows health-care inflation in only a very small way and only for non-union workers beginning in 2017 — doing much more may be impossible. One way to make some progress in improving healthcare is by reducing fraud. If the Centers for Medicare & Medicaid Services simply did what credit card companies do, we’d catch 80% of the estimated $70 billion of fraud each year. This should be a top priority. Between 2004 and 2007, federal revenues went up by over 40%. This was because we had sustained economic growth, which is always a necessary ingredient for more federal revenues. Without growth, we cannot hope to reduce the debt in a serious way, no matter how much more we cut spending or increase tax rates. In 2013 we will find out if the president comprehends this.