A Guide To An Eventual Budget Deal

The federal government is approaching the financial equivalent of the “triple witching hour” (when index future, index options, and individual stocks options all expire during the last hour of trading on the third Friday of certain months) at the end of this year. The Bush tax cuts expire, $1.2 trillion in spending cuts over the next decade are automatically triggered if Congress and the Administration can’t first agree to a $1.5 trillion deficit-reduction package, and the debt ceiling will require renewal. The conventional wisdom is that these issues are only likely to be seriously considered during the lame-duck session after the election. And even then, the most likely outcome is that the various deadlines will be modestly extended so that crisis is again averted, until our political leaders can really tackle the issues in 2013.

If and when a budget deal does come — and it must, to avoid an otherwise inevitable meltdown in the financial markets — it is likely to (and should) reflect four principles or features.

First, it should focus largely on spending cuts, specifically those affecting future beneficiaries of Medicare and Medicaid, because the cost explosion in the federal budget is being driven almost entirely by rising health-care costs for an aging population. After suffering years of anemic growth and watching the government bail out profligate companies (however necessary in the short run), the American people are in no mood to accept the huge tax increases required to maintain the current entitlement state. Higher marginal tax rates on incomes earned by those with incomes above $250,000 will not fundamentally alter the long-term deficit trajectory.

Second, any additional revenues required — and there will be have to be some — should be raised by “broadening the base” (closing loopholes) rather than raising marginal rates. In our highly global economy, higher marginal tax rates on individuals and corporations will penalize growth-enhancing activities and/or drive them and the people behind them off-shore. This broader base, lower-rate idea is a central part of the Simpson-Bowles deficit reduction package, and was the motivating force behind the 1986 tax reform engineered by President Reagan and leading Democrats. The other great insight of Simpson-Bowles, which should be part of any larger budget deal, is to put a percentage-of-income cap on overall deductions rather than asking of Congress the politically impossible: to pick and choose which ones (charitable giving, mortgage interest, and state and local taxes in particular) to eliminate or cut back.

Third, the importance of subjecting only future beneficiaries to entitlement program changes cannot be overstated. This notion was first embodied in President Bush’s social security plan proposed in 2005, which would have limited privatization only to individuals under the age of 55. Looking ahead, some form of premium support in lieu of continued fee-for-service reimbursement is inevitable for Medicare, as suggested by Representative Paul Ryan and philosophically endorsed by a number of leading Democratic health care economists. It is appropriate, however, to exempt older, but not yet retired, individuals from this fundamental change in the program since these individuals have only a limited number of working years left before retirement. In contrast, younger workers both have more time to save and, on average, will earn more than baby boomers as the economy grows over time. Meanwhile, an age cutoff has an important and highly practical political advantage in that it should reduce the opposition to necessary entitlement benefit reform from senior citizens who have no way to adjust to a new system and who vote in high numbers.

Finally, policymakers must accept the fact that any “budget deal” will not permanently resolve our long-term fiscal dilemma. Even the vaunted Greenspan-Moynihan Commission in the 1980s did not permanently solve social security’s funding problems. Things change — especially rates of economic growth (which we all hope will improve) and health-care price inflation that will both heavily affect future entitlement spending. It is unrealistic to expect that forecasts made now about deficits 50 years or more in the future will be even close to correct.

Accordingly, the American people and the bond markets should be happy with a deficit deal that realistically promises to “bend the deficit curve” significantly over a 10-year horizon at a minimum. Given the high level of political discord in the country now, it is the best we can hope for after the election, when it will be time to get serious.