The Fiscal Cliff--Posner

The “fiscal cliff” refers to a federal law scheduled to take effect on January 1 that will rescind the Bush tax cuts and make other adjustments to federal tax laws, with the overall effect being to increase tax rates and at the same time slash discretionary federal spending, much of it defense spending, across the board. If the “fiscal cliff” takes effect and remains in effect, it is estimated that over a ten-year period it will increase federal tax revenues by about a trillion dollars and cut federal spending by approximately the same amount. 

This would do wonders for the federal deficit (the annual increase in the federal debt), slashing it in half (by $200 billion) in 2013 and presumably in each of the subsequent years as well—or would it? The increase in the deficit since the 2008 financial crash has been due mainly to the depression (as I insist on calling the “Great Recession”—its political consequences alone may turn out to be as great as those of the Great Depression of the 1930s). The depression has reduced federal income tax collections (because people’s incomes have fallen) and increased spending on unemployment
insurance and other depression-fighting spending measures (the “automatic stabilizers,” designed to smooth the business cycle by increasing tax revenue/reducing government spending in booms and increasing government spending/reducing tax revenue in busts). A substantial increase in taxes will
reduce private spending, and in turn the production of goods and services and therefore employment, while reducing government spending will reduce incomes and so increase the depressive effect on spending of higher taxes; both the tax increases and the spending decreases will reduce disposable income. The overall effect may be to offset the deficit reduction that would occur if the “fiscal
cliff” law would have no effect on disposable income and therefore on production and employment (and therefore on income and tax revenue). 

The President has proposed to avert the fiscal cliff by replacing the fiscal cliff law with a new law, the main provision of which would be to rescind the Bush tax cuts for anyone earning less than $250,000 a year. This is opposed by conservative Republicans on the ground that the President is proposing a tax increase for everyone earning $250,000 or more. That is incorrect. Their taxes will rise beginning on January 1 if the fiscal cliff is not averted; the President’s proposal therefore does not alter their tax liability, as the law would go into effect the same day that the fiscal cliff (if not replaced by his proposed law) would raise everyone’s taxes. 

The Republicans are concerned about the deficit, and, being unwilling to reduce it by increasing tax rates even just relative to the low rates adopted early in the Bush Administration (when the deficit was small), want heavy cuts in spending but not in defense spending. The amount of nondefense discretionary spending is small, however, so the Republicans want the cuts to be concentrated in entitlement programs, mainly Social Security, Medicare, and Medicaid. Obama resists these cuts, because the entitlement programs are immensely popular, particularly though not only among Democrats; and though he is willing to make some cuts (mainly by adjusting the formula for raising
social security benefits to keep pace with inflation) in exchange for rescinding the Bush tax cuts, he is unwilling to make the kind of cuts the Republicans want. At this writing, so many Republican Congressmen are adamant against any action on the existing (pre-cliff) tax rates that no compromise is possible unless the Speaker of the House is willing to advocate a compromise that will attract enough Democrats and Republicans to create a majority. 

It ought to be easy for the Republicans to agree to some variant of the Obama proposal. The tax “increases” would affect only 2 percent of the population, and they are modest increases; the negative effect of such increases on spending and investing would probably be small, and perhaps
completely offset by the effect, modest as it would be, of the higher tax revenues in reducing the deficit. And remember that the tax “increases” proposed by Obama are not really increases, but merely reductions in the Bush tax cuts and in the “fiscal cliff” taxes now scheduled to go into effect on January 1. Before Bush’s tax cuts there was very little sense that Americans are overtaxed, especially Americans with high incomes. 

The conservative Republicans find themselves in a difficult position: they want to reduce the deficit, but they don’t want to raise any tax rates. They are open to tax reforms that would generate additional tax revenues, but such reforms, mainly reducing tax deductions, are very difficult to achieve politically because the main deductions—mortgage interest, charity, and state taxes—are extremely popular. The Republicans advocate spending cuts, but draw the line at cutting defense spending, and so cannot achieve substantial deficit reduction without big cuts in entitlement spending, but as I said the principal entitlement programs are very popular—even Medicaid, which supplements social security benefits for many people, and is already underfunded. 

During the election campaign, Romney was criticized for wanting to deal with the deficit solely through capping deductions and reducing nondefense spending, without specifying the deductions that would be capped or the size of the caps, and without specifying what major entitlement programs would be cut and if so by how much. He seemed to have taken Medicare off the table. It remains unclear what specific, feasible, and substantial measures the Republicans propose for reducing the deficit. 

Realistically, the best we can hope for at the present time is a modest increase in tax revenues along the lines proposed by the President, some modest cuts in discretionary and entitlement spending—tax and spending measures that will reduce the deficit, albeit not dramatically, without interrupting the
gradual recovery of the economy from its doldrums—and the prospect that continuing economic recovery will reduce the deficit quite apart from changes in tax revenues or spending.

Comments

[jim kirby]

I think you mean "rescind the Bush tax cuts for anyone earning MORE than $250,000 a year."

[Mark Hazelbaker]

Judge, your comment is interesting and insightful. Do you believe that you would have to recuse yourself from a case dealing with the application of this statute if it came before the Seventh Circuit?

[Terry Bennett]

Jim - I think he means Obama's proposal would rescind the EXPIRATION of the Bush tax cuts for people making LESS than $250k.

Entitlements aren't going anywhere right now. It will take a Herculean effort to rearrange the way much of the country lives, having now come to depend on Social Security and Medicare, and there is no will to change that, among either the populace or the representatives thereof. The poor have voted themselves a pay raise, and they continue to have the votes to make it stick. That's a fight for another decade, after we endure a further measure of suffering.

I agree with Judge Posner that the best we can hope for is that the bureaucrats end up doing negligible harm and the economy heals on its own. I see no chance that government will help the economy. The Republican agenda is under heavy attack, and even appears contrarian and absurd on its face, but it is a necessary counterbalance to Obama's plan to spend us into oblivion. I can only hope that a compromise is reached and the government can once again return to irrelevance, letting us stabilize and grow not because of policy but in spite of it.