America’s fiscal cliff dwellers

WASHINGTON, DC – In early 2012, Federal Reserve Chairman Ben Bernanke used the term “fiscal cliff” to grab the attention of lawmakers and the broader public. Bernanke’s point was that Americans should worry about the combination of federal tax increases and spending cuts that are currently scheduled to begin at the end of this year.

But there is not really any kind of “cliff” in the sense that if you stepped over the edge, you would fall fast, land on something hard, and not get up for a long time. In the modern US economy, the scheduled changes constitute more of a fiscal “slope” – meaning that the full effect of the tax increases would not be felt immediately (income withholding takes time to adjust), while the spending cuts would also be phased in (the government has some discretion regarding implementation). This slope offers President Barack Obama a real opportunity to restore the federal government’s revenue base to what it was in the mid-1990’s.

The choice of words to describe America’s fiscal situation matters, given the hysteria that has been whipped up in recent months, primarily by people who want to make big cuts in the country’s two main entitlement programs, Social Security and Medicare. Their logic is that if we are about to rush off a cliff, we need to take extreme measures. And cutting pensions and health care for the elderly certainly qualifies as extreme – as well as completely inappropriate and unnecessary.

If, instead, the US faces a fiscal slope, then people who refuse to consider raising taxes – namely, Republicans in the US Congress’s House of Representatives – have a very weak hand indeed.

It has become clear that the House Republicans will steadfastly refuse to vote for any increases in tax rates during the current lame-duck congressional session. House Speaker John Boehner, who offered relatively conciliatory remarks immediately after the election, now says that he would accept higher revenue with lower rates – precisely what the temporary tax cuts enacted by George W. Bush’s administration were supposed to deliver, but manifestly did not.

It is very unlikely that congressional Democrats and Republicans can reach an agreement on extending the Bush-era tax cuts for the middle class, while allowing them to expire for the rich. They will spar with each other for another six weeks, then go to the brink of the purported “cliff” and see who blinks at the last moment.

The sensible course of action for Obama would be to step off the “cliff” by vetoing any extension of the Bush-era tax cuts, which would then expire at the end of 2012. Once tax rates were restored to their previous levels, Obama could present his own tax-cut package to Congress – for example, with a proposal in early January that provided greater benefit to lower-income Americans, as he promised during his re-election campaign.

These tax cuts should also be linked to the state of the economy, so that they would wind down as employment recovers (for example, to its level in 2007, relative to total population). If the economy looks weaker than anticipated in early 2013, the proposed tax cuts could be larger (as long as they were phased out during the economic recovery). This approach would significantly transform America’s longer-run fiscal prospects.

Then, as America heads steadily down the fiscal slope in early 2013, the House Republicans would have a choice. Do they vote, week after week, against tax cuts that would help 100 million Americans, while the economy deteriorates around them? Or do they embrace a deal that cuts taxes and tax rates relative to where they would be otherwise?

If effect, the House Republicans can be forced to sign onto a deal that both supports the economy and restores revenue to the level that prevailed before the disastrous experiment of Bushonomics.

Obama has already put spending cuts on the table – probably to a greater extent than would please his electoral base (he does have a tendency to do this). The big question is whether the US can strengthen revenue in an appropriate manner that is consistent with renewed economic growth.

America should aim to return to the tax rates of the mid-1990’s, when the economy was booming and the federal budget was in much better shape. But it should do this fully only once the economy has completely recovered.

Ordinarily, partisan political gridlock in Washington would prevent any such sensible change. Fortunately, the fiscal slope gives Obama the opportunity to bring it about – and even to write some history in the process. That means vetoing any extension of the Bush-era tax cuts, and then working to enact the Obama tax cuts.

Author: Simon Johnson is a professor at MIT’s Sloan School of Management and the co-author of White House Burning: The Founding Fathers, Our National Debt, And Why It Matters To You

The opinions expressed here are those of the author, not necessarily those of the World Economic Forum. Published in collaboration with Project Syndicate.

Image: The U.S. Capitol Dome on Capitol Hill in Washington REUTERS/Larry Downing