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.
A cap on the tax reductions derived from tax expenditures that is equal to 2 percent of each individual’s adjusted gross income would raise more than US$200 billion next year if applied to all of the current deductions and to the exclusions for municipal-bond interest and employer-paid health insurance. Even if the full deduction for charitable gifts is preserved and only high-value health insurance is regarded as a tax expenditure, the extra revenue next year would be about US$150 billion. Over a decade, that implies nearly US$2 trillion in additional revenue, without any increase in tax rates from today’s levels.
Extra revenue of US$150 billion next year would be 1 percent of GDP and could be too much for the economy to swallow, particularly if combined with reductions in government spending and a rise in the payroll tax. However, the same basic framework could be used by starting with a higher cap and gradually reducing it over several years. A 5 percent cap on the tax-expenditure benefits would raise only US$75 billion next year, about 0.5 percent of GDP; but the cap could be reduced from 5 percent to 2 percent over the next few years, raising substantially more revenue when the economy is stronger.
Slowing the growth of government spending for Medicare and Social Security is necessary to prevent a long-term explosion of the national debt or dramatic increases in personal tax rates. Those changes should also be phased in gradually to protect beneficiaries and avoid an economic downturn.
The US’ national debt has more than doubled in the past five years and is set to rise to more than 100 percent of GDP over the next decade, unless changes in spending and taxes are implemented. A well-designed combination of caps to limit tax expenditures and a gradual slowing of growth in outlays for entitlement programs could reverse the rise in the debt and strengthen the US economy. The US’ current budget negotiations should focus on achieving a credible long-term decline in the national debt, while protecting economic expansion in the near term.
Martin Feldstein, professor of economics at Harvard, was chairman of former US president Ronald Reagan’s Council of Economic Advisers and is a former president of the US National Bureau for Economic Research.
Copyright: Project Syndicate