Orszag Is Half Right On the Fiscal Gap

Last week, Peter Orszag turned some heads with his New York Times op-ed saying that we should extend all the Bush tax cuts for two years and then let them all expire. I agree with some, but not all, of the Orszag op-ed, and I think he made a particularly important point that has often been lost in the recent debate: you don’t extend (or end) the tax cuts in a vacuum. The decision should be made as a component of the larger fiscal adjustment that will inevitably come this decade.

I agree with Orszag that we should try to address the fiscal gap all at once, and that we shouldn’t do it right now. This is the wrong time, both politically and economically, for painful fiscal actions at the federal level. “Never raise taxes in a recession” is a good principle. And rock-bottom interest rates mean that postponing the fiscal adjustment is not very expensive, at least for now.

Orszag proposes to push the Bush tax cuts out for two years. I think three is better-Orszag’s timing would have Congress debate long-term tax reform in the middle of a presidential election campaign, which seems unproductive, and I’m also unconvinced that the economy will be on strong enough footing in 2012 to talk about fiscal consolidation. Hopefully we’ll be ready by 2013.

What should we do then? Let’s start with the part nobody wants to hear: closing the fiscal gap will, and should, involve a significant tax increase. That’s because keeping current tax policies in place (aside from temporary tax cuts in the stimulus package) would bring in federal revenues of just 18% of GDP over the next decade.

For comparison, that’s below the 19% of GDP revenue target in Rep. Paul Ryan’s “Roadmap” fiscal reform plan, which nonetheless requires sharp entitlement cuts to achieve budget balance. It’s also a bit below the postwar average of federal tax receipts, even though demographic changes and rising health care costs have made entitlement programs structurally more expensive-not entirely in ways that could or should have been avoided.

CBO’s 10-year federal spending projection is 23.3% of GDP, but the figure rises to 23.8% if you patch the AMT and extend the Bush tax cuts, due to increases in net interest. Federal revenues at 18% of GDP are simply too low to sustainably fund a politically plausible set of spending policies, even in a scenario where Washington politicians suddenly become serious about entitlement reform. The fight to be had is over moving to a revenue equilibrium a bit above the postwar average and restraining spending to make that work; or letting growth in entitlement and defense spending push the federal tax take over 20% of GDP.

So Orszag is right that a tax increase is necessary. But he is wrong to propose a fiscal adjustment that occurs principally on the tax side, and he understates the total amount of adjustment needed. In his op-ed, he says we will need an adjustment of 1-2% of GDP. But CBO’s 10-year budget projections, assuming extension of all the Bush tax cuts and the AMT patch, project a 10-year budget deficit of 5.8% of GDP.

To get budget deficits down into line with the postwar norm-i.e., under 2%-will require an adjustment around 4% of GDP, or about $750 billion per year. Obama’s proposal to end the Bush tax cuts for people with high incomes will only close about 10% of this gap-and even Orszag’s proposal to let the Bush cuts fully expire only gets us a bit more than halfway there. Meanwhile, Orszag only calls for spending cuts of 0.5% of GDP. Assuming you continue to patch the AMT, Plan Orszag would still leave us with a 3.0% of GDP federal budget deficit in 2020.

This isn’t dire like an expectation of deficits over 5% of GDP in perpetuity, but I also don’t believe it qualifies as “sustainable.” If we ran 3.0% of GDP deficits forever, with GDP growth averaging 4% in line with CBO projections, our debt-to-GDP ratio would stabilize in the mid-70s, a level the United States has never before reached except during World War II. Stabilizing the debt at a more normal level-below 40% of GDP-will require a much lower average deficit, around 2% of GDP.

So just as we will need tax increases, the fiscal adjustment will have to include large spending cuts. Orszag dismisses with a hand-wave the idea of substantial near-term savings in the federal budget-but because the fiscal adjustment we need is so large, it is time to talk about reforms that we would usually write off as too politically difficult.

Orszag rightly points out that the Affordable Care Act slows the growth of Medicare spending and that further cuts in reimbursement rates are probably not workable without broader reforms to the health care system. (Indeed, we’ll be lucky if Congress resists the impulse to reverse those cuts once seniors start complaining.) But other Medicare savings are available by introducing more means testing, or by raising the eligibility age along with the already-scheduled rise for Social Security.

Since the ACA will provide premium subsidies to adults who cannot afford to buy their own insurance, a rise in Medicare’s eligibility age will be more appropriate than ever in 2014. And the talk inside the president’s deficit commission that apparently has liberals alarmed-about the need for price signals and cost-sharing in health care-is a good sign: such reforms can bring down health care costs without further cutting reimbursement rates.

Other savings are available, too. Senator Tom Coburn and others on the deficit commission are bringing long-overdue scrutiny to our defense budget, including employee compensation, and are likely to recommend significant savings. We spend just over 0.1% of GDP on farm subsidies, which are not just wasteful but actually harmful; we should end them, as Congress tried to do in 1997. And once the economy recovers, the federal government should freeze aid to states in areas that have too often seen insufficient fiscal discipline at the local level: education and public safety.

The core of the debate over the fiscal adjustment will be balancing these sorts of spending cuts against tax increases like full expiry of the Bush tax cuts or imposition of a VAT. Orszag’s preferred solution would have revenues around 20.6% of GDP by 2020. I’d aim about a percentage point lower in order to preserve some of the Bush-era cuts in capital taxes and repeal the Medicare tax surcharge in the ACA. But whatever we hash out will have to involve revenues higher than 18% of GDP and spending lower than 23% of GDP-there will be no fiscal adjustment on just one side of the ledger.

If we need such a large fiscal adjustment, you might be tempted to ask why we don’t take a down payment on it now-even Orszag notes that his most preferred policy would be to end the Bush tax cuts for the wealthy now and the rest later. As a matter of pure policy, I don’t think this would be a large problem if the tax increase were offset by other expansionary fiscal policy, like a brief payroll tax holiday. But politically, it would be very unwise.

When cutting taxes or raising taxes, Washington politicians usually resort to making the tax code more progressive in order to make the tax reform package saleable. From 1991 to 2004, through several rounds of tax increases and decreases, the effective federal tax rate on the top quintile (including all kinds of taxes) fell by 5.4%. But for the bottom quintile, it fell by 10.7%. (These are relative declines, not percentage-point declines.)

What this means is that, if we do our fiscal adjustment in two rounds, it will have to involve substantial tax increases on the rich in both rounds. I agree with Orszag’s premise that the Clinton-era tax rates on earned income are acceptable. But if we agree to take the top federal rate back up to 40% in Fiscal Adjustment I (and then raise Medicare taxes for high earners when the ACA comes into effect) where will it be after Fiscal Adjustment II? Probably north of 45%-and that’s a real problem.

Indeed, the federal tax code probably ought to become less progressive as a result of the upcoming fiscal adjustment. Because the dead weight-loss of a tax (the reduction in economic activity it causes) is a function of the square of its rate, increases in already-high marginal tax rates are inefficient ways to raise new revenue. So as the government grows larger (and so does the tax share of GDP) it becomes more necessary to rely on less progressive tax sources.

The United States has one of the most progressive tax systems in the industrialized world, and for good reason-we have historically had far less means-tested entitlement spending than most wealthy countries, meaning that the spending side of our government ledger is much less progressive than normal, and we also spend less overall. As these spending-side attributes wane, so too should the unusual progressivity of our tax code. But this will be politically very difficult to achieve. Opening with a tax increase that falls solely on the wealthy will make it even harder.

Fortunately, we don’t have to figure these things out right away. It is important that we fix the fiscal gap soon-letting our current budget trajectory continue indefinitely will lead us to a Greek-style fiscal collapse. But “soon” and “now” are not the same thing. Fixing the gap in 2013 is early enough, and a complete three-year extension of the Bush tax cuts will buy us time to have that debate in an environment that is less politically and economically fraught.

This piece originally appeared in RealClearMarkets

This piece originally appeared in RealClearMarkets