Commentary

Misreading the Fiscal Cliff

The fiscal cliff is now less than six weeks away. Negotiators are reportedly locked away behind closed doors working on a grand bargain to avoid the tax hikes and spending cuts that will hit on January 1. Most of the debate so far has centered on how best to raise taxes on the wealthy: whether to increase tax rates, as the president demands, or eliminate deductions and loopholes, as some Republicans seem to be open to considering. Unfortunately, these priorities are almost entirely upside down.

Therefore, let me offer some unsolicited advice for the negotiators:

You can’t hike taxes on the rich enough to balance the budget. President Obama has called for $1.6 trillion in tax hikes over the next ten years. While that is large enough to do serious damage to the economy, it would amount to just 16 percent of the combined deficits that we are projected to face over that period. In fact, the president’s proposed tax hike doesn’t even cover the $2.6 trillion in spending increases that he has called for over the next ten years. Obamacare alone will add $2.15 trillion in federal spending by 2022.

Worse, none of this accounts for the rapidly accumulating unfunded liabilities of Social Security and Medicare. Washington tends to focus on our $1.1 trillion budget deficit or our $16.2 trillion national debt, but our real debt, including those unfunded liabilities, is somewhere between $78.5 and $128.2 trillion. As I have pointed out before, you could confiscate — not tax but confiscate — every penny belonging to every millionaire and billionaire in America, and still not have anywhere near enough money to pay for all that we owe.

Of course, even these estimates assume that hiking taxes will actually generate more revenue. It is worth noting, for instance, that Great Britain hiked its top tax rate from 40 to 50 percent in 2010 as part of a deficit-reduction package. The tax hike was supposed to raise an additional £2.4 billion in 2010–11, but actually brought in £5 billion less than was expected without the rate rise (Britain cut tax rates again in the 2012 budget). This should be no surprise. Not all tax cuts pay for themselves (as some Republicans mistakenly believe), but there is a limit to how much taxes can be raised before they begin to create disincentives for work, saving, and investment that prove counterproductive. For example, Veronique de Rugy, a senior research fellow at the Mercatus Center and an NRO contributor, has pointed out that revenue as a percentage of GDP has held relatively constant over the past 80 years regardless of the top marginal tax rate.

Arguing about what taxes should be raised is a distraction from the real issues.

That’s because we have a spending problem. As my colleague Dan Mitchell points out, all that is necessary to balance the federal government’s budget is for government spending to grow more slowly than the economy as a whole. In fact, the Congressional Budget Office predicts that even without any tax hikes, government revenue will reach 21.4 percent of GDP by 2022, significantly higher than its postwar average. Why, then, will we still have a deficit? Because spending that year is expected to exceed 22 percent of GDP, compared with a post-war average of 19.8 percent, and just 18.3 percent as recently as Bill Clinton’s presidency.

According to the CBO, even if we never add another government program, federal spending will reach 46 percent of GDP by mid-century. True, some of that spending is interest on an ever-rising debt, but even if one assumes that the government had no interest expenses beyond those on the $16.2 trillion it currently owes, federal-government spending would still approach 30 percent of GDP by 2050. There is no possible way to raise taxes enough to pay for that amount of spending without wrecking the economy.

President Obama claims that his plan includes spending cuts — in fact, $3 in spending cuts for every $1 in tax hikes. But he hasn’t actually offered any details beyond smoke and mirrors. The president’s plan, for example, includes $1 trillion in spending cuts that were already agreed to as part of the 2011 debt-ceiling deal, a neat exercise in double-counting. He also includes savings from not fighting a war in Iraq or Afghanistan after 2014, money that was never going to be spent in the first place. And, finally, he includes $634 billion in savings from not having to pay interest on the phantom spending he’s cut. More realistic estimates suggest that the president is actually proposing almost $3 in tax hikes for every $1 in spending cuts.

Even those spending cuts are not real cuts, in the sense of less money being spent, but simply reductions in the baseline rate of increase. And while the president’s proposed tax hikes would go into effect immediately, the spending cuts are pushed off into the dim and distant future. In fact, according to recent reports, the president actually wants new stimulus spending in the short term, to be followed by spending cuts once the economy has bounced back.

We’ve been down this road before. Fans of Charles Schulz’s Peanuts know that every fall Lucy promises Charlie Brown that this time she really means it when she says that she will hold that football for him to kick. Yet, somehow, every time she finds a reason to pull that football away and Charlie Brown ends up flat on his back.

In 1982, Ronald Reagan agreed to raise taxes as part of a deal that promised $3 in spending cuts for every $1 in tax hikes. By the time Reagan left office, tax receipts had indeed risen by $290 billion. But not only had spending not been cut, it had actually risen by $318 billion, an increase in spending of $1.10 for every $1 in new taxes. The result was an even bigger budget deficit than the country had before the deal passed. Writing in his memoirs, Reagan called the tax-and-spending agreement one of the biggest domestic mistakes of his presidency, noting that “later the Democrats reneged on their pledge and we never got those cuts.”

In 1990, President George H. W. Bush approached the football, famously breaking his “read my lips, no new taxes” pledge, and agreed to a deal that promised $2 in spending cuts for every $1 in taxes. As with Reagan, the tax hikes proved all too real, an almost $60 billion increase by 1992. But once again, not only did the spending cuts fail to materialize, spending actually increased by $128 billion, a $2.10 increase for every $1 in tax hikes. The deficit, of course, increased as well.

If that seems like distant history, the 2011 deal to increase the debt limit promised $1 trillion in spending cuts, even before the upcoming sequester. Instead, spending since then has increased by $132 billion. And both Republicans and Democrats are currently scrambling to avoid the sequester’s cuts as well.

The real issue is the size of government. As Milton Friedman used to point out, the real cost of government is what it spends, not whether that spending is paid for by debt or taxes. Spending more than we take in is demonstrably a bad thing. But raising taxes sufficiently to support an ever-growing government is not appreciably better. Consider this: Would we be better off with an unbalanced $1 trillion federal budget or a balanced $3.7 trillion one?

As noted above, federal spending is set to rise to 46 percent of GDP by 2050. When you add in state and local spending, government at all levels will be consuming more than 60 percent of everything produced in this country. We cannot long remain economically productive or personally free with a government of that size.

Any grand bargain, therefore, must include significant reductions in government spending. These cuts must be real, actual cuts, not just reductions in the rate of growth, and must occur now, not in the “out years.” They should include structural reforms to deal with the insolvency of Social Security and Medicare.

If we accept anything less, we may soon find ourselves longing for the days of the fiscal cliff.