Where do we go from here?

There is little time for respite after the election with a pressing economic issue at hand.
November 12, 2012

 

Now that the election is over, President Barack Obama and Congress have some serious challenges right ahead of them. First among them is the so-called fiscal cliff. Beginning Jan. 1, a number of tax cuts will expire and automatic spending cuts will be
triggered.

This combination of tax hikes and spending cuts would have a sudden shock on the economy. If left untouched, the Congressional Budget Office and other private forecasters predict that these automatic tax hikes and spending cuts will put the U.S. economy back into recession. That’s not to say the economy couldn’t crawl back out of the ditch, but the last recession didn’t sprout a lot of glee.

This week, Obama and Speaker of the House John Boehner began laying out their plans to avert the fiscal cliff. Obama and the Democrats prefer to raise taxes on the wealthiest 2 percent of Americans while preserving the Bush tax cuts for the middle class. Boehner has spoken adamantly against tax increases, citing their effect on businesses, and instead proposed cutting special interest loopholes and deductions.

Democrats and Republicans appear to be in a stalemate over the tax rate increase on the rich. If they truly want to come together, they’ll have to find creative solutions. A good place to start is with caps on deductions. Republicans are already in favor of this type of reform, and it could be the best way to
raise revenue.

According to a recent report by the Tax Policy Center, reasonable limits could be very effective. Capping deductions at $50,000 would raise an estimated $749 billion over 10 years without changing the present tax rates. A $25,000 cap could raise $1.3 trillion.

Furthermore, the $50,000 cap would raise revenue overwhelmingly from the wealthy. A little more than 96 percent of the revenue would come from the top quintile and 79.9 percent from the top 1 percent of earners. Though some middle-class households would be affected, their burden would be small. The average tax increase on the middle quintile would be a mere $12.

This could be the best place to begin compromise in Washington. By winning additional revenue, Democrats may have to allow for some reform of entitlements, such as gradually increasing the age of eligibility for Social Security and Medicare.

But before getting too deep into nitty-gritty proposals for solutions, let’s take a step back and ask a simple question. What does it mean to “avert the fiscal cliff?” What is the mutual goal here? The conversation is focused almost entirely on deficit reduction. Ironically, that’s precisely what the fiscal cliff is, an automatic reduction of the deficit. The struggle to “avert the fiscal cliff” is not actually about avoiding it, it’s a debate over how to rappel safely down it. No one seems to be surprised that the focus is on deficit reduction, but it’s a bit of a shift from Obama’s earlier economic
policies.

During the recession and its aftermath, a variety of legislation was passed to boost the economy, such as: the stimulus package, Cash For Clunkers, extending unemployment
benefits, etc.

 These policies were based on Keynesian economics, which says that during an economic downturn, the government should spend money by incurring a budget deficit to reinvigorate aggregate demand, almost like jump-starting an engine. If you pump extra money into the economy to be paid for in the future, it provides a short-run boost.

However, even after all of those policies, the economy is struggling to pick up speed. Some strict Keynesian economists argued both before and afterward that the stimulus package was too small. Many in the Austrian and Real Business Cycle economic disciplines expressed skepticism that the stimulus was the best solution. However, there is little doubt that the stimulus at least slightly curbed the recession in the short term. The serious debate is about how effective it was and whether the long-run effects, such as the need for future taxes to pay for it, were worth it.

Well, the long run is here. Our deficit is more than a trillion dollars, and both the left and the right are trying to cut it down. However, the engine is still sputtering, therefore, a true Keynesian would not be thinking about deficit reduction right now. This is the real surprise. Washington, D.C., which just three years ago was all in adulation of John Maynard Keynes, particularly among Democrats, seems to have turned its back on
him.

Considering that Obama won the election, it’s a plausible prediction that he will win some kind of tax increase on the rich in conjunction with spending cuts. So, the persistent Keynesians won’t get the stimulus they prescribe.

The Austrians, RBC theorists and other stimulus skeptics lost their prescription battle in 2009. Other conservative economists may lose their battle against growing government all while it happens concurrently with contradictory fiscal policy. In the end, we’re just left with the old shibboleth about compromise: It’s a solution that leaves everyone
unsatisfied.

We tried stimulus. Success? Debatable. Now it looks like we’ll try austerity. Success? There’s only one way to find out. 

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