The US may be headed for a recession next year. Even if the country avoids going over the “fiscal cliff,” a poorly designed political compromise that cuts the deficit too quickly could push an already weak economy into recession.
However, a gradual phase-in of an overall cap on tax deductions and exclusions (so-called tax expenditures), combined with reform of entitlement spending, could achieve the long-run fiscal consolidation that the US needs without risking a new recession.
The US economy has been limping along with a growth rate of less than 2 percent during the past year, with similarly dim prospects for next year, even without the shock of the fiscal cliff. That is much too weak a pace of expansion to tolerate the fiscal cliff’s increase in tax rates and spending cuts, which would reduce demand by a total of US$600 billion — about 4 percent of GDP — next year, and by larger sums in subsequent years.
US President Barack Obama’s proposed alternative to the fiscal cliff would substantially increase tax rates and limit tax deductions for the top 2 percent of earners, who now pay more than 45 percent of total federal personal-income taxes. His budget would also increase taxes on corporations and would end the current payroll-tax “holiday,” imposing an additional 2 percent tax on all wage earners.
Together, these changes could lower total demand by nearly 2 percent of GDP. The higher marginal tax rates would reduce incentives to work and to invest, further impeding economic activity. All of that could be fateful for an economy that is still struggling to sustain a growth rate of less than 2 percent.
The US Congressional Budget Office and the US Federal Reserve predict that going over the fiscal cliff would cause a recession next year, with US Federal Reserve Chairman Ben Bernanke recently saying that the Fed would be unable to offset the adverse effect on the economy. He could have said the same thing about the fiscal drag that would be created by Obama’s budget proposal.
Although congressional Republicans rightly object to raising tax rates, they appear willing to raise revenue through tax reform if that is part of a deal that also includes reductions in the long-run cost of the major entitlement programs, Medicare and Social Security.
Although some Republicans would like to see revenue increased only by stimulating faster economic growth, that cannot be achieved without the reductions in marginal tax rates and improvements in corporate taxation that the Democrats are unlikely to accept. Raising revenue through tax reform will have to mean reducing the special deductions and exclusions that now lower tax receipts.
The potential recession risk of a budget deal can be avoided by phasing in the base-broadening that is used to raise revenue.
A desirable way to broaden the tax base would be to put an overall cap on the amount of tax reduction that each taxpayer can achieve through deductions and exclusions. Such an overall cap would allow each taxpayer to retain all of his existing deductions and exclusions, but would limit the amount by which he could reduce his tax liability in this way. An overall cap would also cause many individuals who now itemize deductions to shift to the standard deduction — implying significant simplification in record-keeping and thus an improvement in incentives.