Both the Democrats and Republicans drew lines in the sand in recent days about what their side is willing to give in the debt deal. With these lines drawn, we are beginning to see what the battle will look like, and our predictions are being recognized.
Obama and Democrats came out early and said that taxes must go up on those making above $250,000, that entitlements were off the table, except for making medicare “more efficient”. Later, the Republicans led by Speaker Boehner and Senate Minority Leader Mitch McConnel, said that tax rates must be held but they would accept some tax increases in the form of closing loopholes. But for this to work, they need to see some cuts in entitlement programs, mainly medicare.
I’ve already spoken about the fiscal cliff, so I’ll save you the time of having to re-read it (here and here) but in essence a deal will have to be reached by the end of the year or taxes will go up and cuts will be made that people in Congress don’t like (although I still see an extension happening before then).
So what do these drawn lines tell us?
Well Medicare has already been agreed to be on the table, expect some overhaul of the program. I think in this case “more efficient” means we can cut it. It looks like this is the entitlement casualty that I previously predicted. By cutting medicare we could probably save about 50 billion dollars in 2013, and up to 100 billion dollars in 2022 (assuming the cut were between 8-10% of the program costs, which is mighty deep).
Social Security is off the table. I don’t see either party pushing for major reform, both candidates avoided it during the presidential race as well. What we may see is a call to increase the retirement age to something along the lines of 70-72. But I don’t see this actually getting through negotiations. No one likes to hear their age of retirement is being increased, again. For the Democrats, also this largely affects low-income individuals and manual laborers for whom life expectancy does not justify such an increase in retirement age.
Loopholes will be closed, both parties agree and even Mitt Romney argued doing this. The closing of loopholes, will have one of two effects. First, it will largely affect high-income households who tend to use these loopholes in greater degree. Second, with one closed loophole comes another to squeeze into. Accountants and Tax Professionals are paid big bucks to figure ways to game the system, perhaps they just find another avenue. The amount of savings from closing loopholes is totally unknown, it depends on which loopholes are closed and which deductions are allowed to expire. The New America Foundation, using congressional reports, estimates that there is roughly $700 billion per year that is lost in revenue through loopholes and deductions. That is pretty huge. Perhaps the budget negotiation can free up a hundred or so billion from that.
Tax rates will surely be a sticking point. This is going to be the big battle. Obama has said tax rates for the 250k’rs have to go up, Republicans have said no. This is where negotiations will come in. The $250,000 figure may be raised to $500,000 or $1 million with little to no other changes. Or what I suspect is that Democrats will hold military spending as the Republican lamb awaiting slaughter unless this change is made. By saving military spending and offsetting it with tax increases the Democrats may win the battle. The most disseminated figure of budget savings suggests this tax increase (from the expiration of the Bush Tax Cuts) would amount to $700 billion over a decade. A further increase in marginal tax rates for the upper incomes would generate additional income.
And what about other types of spending cuts? Again, Military is certainly on the line, with the two wars winding down there is extra money just waiting to be cut. Domestic programs and some federal agencies may be lobbying their friends now to save them for the chopping block – we will see how that works out.
If you read my economic tightrope article, or just about any other article regarding the domestic economy, you’ll know that I am fearful of the spending cuts and tax increases. While increasing taxes on the wealthy does not appear to hurt growth levels to a large extent, I think it is difficult to say it helps them. What does help is when you convert that additional revenue into transfer payments to low-income people or into pro-growth programs (R&D, infrastructure upgrades etc.)
But because we are trying for a “balanced budget” (quotes are meant emphasize the irrationality) we wont see this increased revenue offset. So in the end, hopefully I’m wrong, and the extension is at least a year and the cuts and tax hikes are superficial at best. There is a difference between smart policy for long-term results and “dumb” policy meant to make numbers look nice in the very short-term.
We’ve seen how Austerity is working, yet most of the country is probably still oblivious and many of our elected officials still want that end. While we aren’t talking the type of austerity being executed in Greece, Italy, Spain, Portugal or Ireland, even to step in that direction somehow astonishes me. It is one thing to be the first, and to have made a mistake, it is another to have 20/20 hindsight and still make them.