Taxes and Fiscal Policy: 2012 in Review

Events in 2012 reconfirmed three long-standing lessons in tax and fiscal policy.

First, imposing austerity in a weak economy not only does not generate a recovery, it can actually make matters worse. Despite massive austerity measures, Greece has been unable to gain traction in the three years since its debt crisis came to light. The UK, which has implemented a severe austerity program under Prime Minister Cameron, is flirting with a third recession. And Portugal’s austerity measures appear to have raised unemployment even faster than was expected and will extend the Portuguese recession into 2013.

Second, although everyone favors it, tax reform requires difficult tradeoffs. This became most apparent during the presidential election, when Governor Romney proposed a set of goals that turned out to be mutually incompatible: cutting income tax rates by 20 percent, eliminating the AMT, repealing the estate tax, and preserving incentives for saving and investment, all while not raising taxes on households with income below $200,000. And that says nothing about reconciling these proposals with the goals of members of Congress, who would have to approve legislation to make tax reform happen.

Third, signing the “No New Taxes” pledge, as more than 90 percent of Republicans in Congress have done, yields bad policy. The signers have pledged not to raise revenues under any circumstances — even, for example, to finance defense of the homeland in case of an imminent enemy invasion. In the past, pledge signers have demonstrated massive fiscal irresponsibility – voting overwhelmingly to cut taxes by substantial amounts in 2001 and 2003, to create a new entitlement in Medicare Part D, to deficit-finance wars in Iraq and Afghanistan, to increase discretionary spending, and so on. Furthermore, the pledge removes all of the Republicans bargaining chips, giving them nothing to offer and Democrats little reason to want to negotiate with them.

In the remaining days of 2012 and in the new year, our leaders in Washington should reflect on the lessons of the past year as they deal with the approaching “fiscal cliff,” the spending cuts and tax increases that are scheduled to take effect January 1st and will likely push the economy toward another recession. They should learn from Europe and instead boost the economy now with temporary stimulus measures, postponing fiscal consolidation until after the economy has recovered. They should learn that, although it is easy to promise tax reform, it is not going to be easy to raise revenue, promote economic growth, and help the middle class. And finally, they should learn that, in the end, politics is about compromise: if you cannot compromise, you cannot govern.