Real Clear Markets

The Fiscal Game in Washington Is at Odds with Reality

Let's play a game. You may find the game rather odd. But stay with me.

You are a legislator in a fictional country. You pride yourself on being fiscally responsible. Under current law, the government will run a small budget deficit. As a result, the nation's debt will increase. But debt will grow more slowly than income. So, the ratio of debt to national income will fall.

Now, as a legislator, you are asked to cut taxes and raise spending—a lot! If you comply, huge and growing budget deficits will result. Debt will grow faster than income. Eventually, the debt will become so large that lenders will lose faith that the nation will have the will or ability to service the debt. When that happens, interest rates will spike and investment will collapse. What position do you take on these proposed tax cuts and spending increases?

Easy question, you say. You vote "no." To do otherwise would be irresponsible.

If that is your position, you have just shown that you would not get very far in current U.S. politics. The fiscal situation that the nation faces is, with one very important exception, precisely that described above. According to projections of the Congressional Budget Office, the currently-large U.S. budget deficits will shrink to manageable levels once the United States returns to full employment.

But there is a condition for that to happen: Congress must not change current law. That is, Congress must not extend any of the tax cuts enacted during the Bush Administration. It must not extend the payroll tax cuts put into effect in 2011. It must not back away from spending cuts set in place in 2011. And it must not repeal the health reform legislation enacted in 2009 or the scheduled cuts in physician fees that Congress has repeatedly postponed.

Yet, pressures for Congress to create a fiscal problem that does not now exist are powerful. Republicans favor extending all of the Bush era tax cuts. Democrats would extend most. Members of both parties are wringing their hands about the spending cuts agreed to last year. Members of neither party seem willing to let physician fees be cut. And the health care reform legislation faces judicial risks of being invalidated and political risks of being stalled or repealed.

The United States of 2012 differs in one crucial respect from the fictional country I described above. The United States is laboriously and slowly clawing its way out of the worst economic slowdown in eighty years. Allowing taxes to rise or spending to fall just now would probably interrupt and would surely delay the return to prosperity.

So, letting taxes rise or spending fall should probably wait a year or two. To speed the recovery, it would even help now to boost spending or cut taxes a bit more. But the last thing that responsible legislators should do now is to make any of the tax cuts permanent or backslide on the spending cuts. If current law remains in effect, there will be no fiscal crisis. Deficits will be well controlled and the debt burden relative to income will shrink.

There would still be a great deal for responsible legislators to do. The nation's tax laws badly need reform. As countless analysts have shown, the current tax system is needlessly complex, it unnecessarily distorts decisions by both consumers and investors, and it does too little to offset the enormous increase in economic inequality that has occurred in the nation over the past 30 years. It would be a great day for the nation if Congress, starting from tax rates that prevailed in 2001, designed a simpler, fairer, more growth-oriented tax system.

The spending cuts agreed to last year were, to put it mildly, not done thoughtfully. Although last year's cuts protected Social Security and programs that help the poor, they were, for the most part, paid no attention to sensible national priorities. It would make a lot of sense for Congress to raise or further cut specific categories of spending, provided that it fully pays for any changes. This recipe is not new or utopian: it simply describes the ‘pay-go' rules that Congress has twice adopted and that helped sustain the policies that turned budget deficits into budget surpluses during the 1990s.

With respect to both taxes and spending, Congress needs to act. After it is agreed that the tax cuts should expire, reforming the tax system should enjoy high priority. After is agreed that current law spending is the baseline, reconsideration of how spending is distributed would also be beneficial.

In simple English, after economic recovery, the budget under current law, is now close enough to balance to be sustainable. We will have a deficit problem only if Congress creates one. Alas, that seems to be the direction in which we are headed.

One other point. I have not said a word about Social Security or Medicare. If Congress does not create a deficit problem, there will be no reason on budgetary grounds to cut either. To be sure, both Social Security and Medicare Hospital Insurance are subject to rules in addition to those governing the budget. Those rules aim to hold spending on those benefits below specifically earmarked revenues, mostly payroll taxes. These rules will require changes-higher payroll taxes or reduced benefits-to keep spending within those earmarked revenues. But no cut in either program is needed to maintain overall fiscal balance.

To avoid fiscal imbalance, only one thing is necessary—Congress must forebear from creating it.