Economics is the only field in which two people can each receive a Nobel Prize for saying the opposite thing. Politics is the only field that will blindly follow either one or the other economic theory to the death, while not understanding either.
Ideologues prefer to furiously argue, even when they may have already solved the problem. Remarkably, the federal deficit will significantly decline by maintaining the existing “dollar-for-dollar” rule – a provision of the 2011 Budget Control Act wisely stipulating that increases in the debt ceiling be matched by gradual reductions in future spending.
The “fiscal cliff” (expiring tax reductions and mandated belt-tightening) and the need to raise the debt ceiling represents a combined negative impact of 4 percent of gross domestic product or about $5,000 annually per household. This is potentially enough to trigger a recession and to force Congress to reconsider its past inaction.
Our economic simulations suggest that a “do-nothing” scenario – or rejecting both tax hikes and existing limitations on spending growth – would increase the federal debt ratio by 75 percent and cut economic growth in half within 10 years. We would be Greece.
Europe and Japan offer some guidance as to where the United States is headed. Analysis of data for 20 developed nations illustrates that a high federal spending level, high deficits and high tax rates all retard growth while increased savings accelerates growth. These data also reveal that:
• Higher taxes do not reduce deficits or debt levels, but enable higher spending.
• Countries with high debt levels have slower growth and higher unemployment.
• Higher tax rates do raise revenue, but at the expense of slower economic growth.
• Most importantly, the negative effects of increased taxes on growth are equivalent to the positive effects of reduced debt on growth.
In other words, if taxes were increased in order to retire debt, there would be offsetting positive effects on growth. However, if taxes were increased and expenditures either not reduced or allowed to increase, both the deficit and debt levels would climb and lead to slower growth.
This is the Catch-22 that both the European Union and the United States are facing. Without reductions in federal debt and spending, higher and higher taxes will lead to slower and slower economic growth in an endless downward spiral.
The U.S. must maintain the “dollar-for-dollar” rule. Again, this means equal cuts in future spending for every dollar increase in the debt limit. This critical guideline, which is already in place, is vastly superior to a “Balanced Budget Amendment” that would require both destabilizing tax hikes and program cuts during periodic recessions or modification as a result of defense needs.
Since Congress has consistently proved itself incapable of making targeted spending cuts, uniform percentage reductions will be necessary across all programs – not just discretionary spending. Only then will Congress begin to prioritize. But if the “dollar-for-dollar” expenditure constraint is abandoned, economic growth rates will continue to decline as federal debt soars.
The “Grand Bargain” would be to give President Barack Obama his $100 billion tax hike on high income earners, but earmark the increase in revenue for interest payments on debt service – currently “paid” simply by selling new bonds. The additional revenue – not much in comparison to a $1 trillion annual deficit – might help to placate uneasy bond rating firms worried that Congress is incapable of even beginning to address debt reduction.
Current income tax rates could be maintained for 97.5 percent of households, but the temporary reductions in Social Security taxes of $100 billion per year would have to be abandoned to help keep that program solvent. The combined $200 billion increase in taxes – or about half the increase contained in the current “fiscal cliff” – in conjunction with the “dollar-for-dollar” rule would:
• Incrementally balance the federal budget over 15 years.
• Reduce the debt/GDP ratio to the 2009 level.
• Freeze federal debt at that point.
The necessary belt-tightening, however, would require a reduction in the growth of expenditures to about 3 percent per year and necessitate major reforms in Medicare and Social Security before more than 75 million baby boomers retire.
Bruce Finnie is senior economist with Fat Tail Systems and also holds emeritus status at Pacific Lutheran University. Linda Gibson is a professor of management at PLU. Contact Finnie at finniebw@plu.edu.
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