Fiscal cliff or fiscal molehill?

Four thoughts, reflecting my frustrations with the "fiscal cliff" debate. 

1. Recession

How terrible will it be if we go over the cliff?

Bad, but for all the wrong reasons. If you, like me, didn't think that "stimulus" from government spending raised GDP in the recession, you can't complain that less government spending will cause a new recession now. The CBO's projections of recession are entirely Keynesian. Pay them heed if you still think the key to prosperity is for the government to borrow money and blow it.

There are no "cuts" in sight anyway. "Cut" in Washington means "increase spending less than we previously said we would." At worst a few programs will have to spend the same amount this year as last before spending increases resume.

It's not even obvious that the "cuts" will happen. Will Congress really try to pay doctors 1/3 less? (Will doctors take any medicare patients if they do?) Or will they pass an "emergency" bill, exempting doctors just like Social Security? Sequestration has never actually been used.

To an economist, the main worry is that higher marginal tax rates mean more distortions, which are a drag on the economy.  But distortions take a while to kick in. It takes a while for people to change to easier jobs, not start businesses, move businesses offshore, not go to school, choose easier but less rewarding majors, find more tax shelters, and so on. So the danger is not so much a recession, which comes, and then ends, and we go back to growth. The danger is settling in to a decade of (even more) high-distortion, sclerotic growth.

The headline rate people are fighting about -- 35% vs. 39.5 % federal income tax rate -- is basically irrelevant to the larger issues. If we had a clear, functional, stable tax system, with a total (all taxes) 39.5% top marginal rate, the economy would heave a big sigh of relief and take off like a rocket.

We have instead a horrendously complex, nay corrupt, tax system. It's chaotic, with teams of lobbyists descending now to carve out everyone's exemption, deduction and subsidy. Tax reform is, in my judgment, more important than the headline marginal rate. More generally, I think the lessons of growth economics are pretty clear that over-regulation and the consequent politicization of economic decisions is a larger danger to growth than any stable clear and uniformly administered taxes with faintly reasonable marginal rates. If you can start a business and know for sure you'll keep half the profits, that's more enticing than never knowing what new holdup you will be subject to from 100 overlapping regulatory agencies.

Furthermore, economics cares about the total marginal tax rate -- everything between the extra dollar you earn and the additional goods you receive -- including Federal, state and local income taxes, deduction phaseouts, payroll taxes, taxes on rate of return between earning and spending, sales taxes, estate taxes if you leave it to your kids, property taxes if you buy property, excise taxes, and on and on. Some parts of Washington seems to finally have figured out that reducing deductions raises taxes with less distortionary effects on marginal tax rates.  They have not so successfully figured out that every phaseout or income test adds to marginal tax rates. In any case, it makes no sense at all to talk about the Federal income tax rate in isolation.  

Economics cares equally about taxes and benefits. Whether you send the government a check or they send you a check doesn't matter, what matters is how that check changes based on your behavior. Marginal tax rates are high for lower income people too (earlier post on the subject). Asset tests are just as bad as income tests: If you save, and then an asset test takes away a benefit such as college aid, you might as well not bother saving. It makes no sense to talk about taxes and not benefits at the same time.

Economics cares about the overall impact of the Government on decisions, not just on-budget taxing and spending. If the government says "employers shall provide $15,000 worth of health insurance to every employee," that does not show up on the budget -- but it has exactly the same effect on the economy as a tax and benefit. If the government says "all gasoline shall contain 10% ethanol," that has the same effect on the economy as a tax and subsidy.

2. Distribution

The same points apply even more to distributional questions -- are the "rich" paying "their fair share," should they "pay more," and so on.  The headline Federal income tax rate is the tip of the iceberg. Economics tells us to consider the overall effect of the government at all levels on the distribution of individual consumption. (Not household, not income, not wealth.)

Obviously, we have to talk about taxes and benefits in the same breath here. We also need to talk about who benefits from government spending and intervention. There's a lot of corporate welfare, which ends up in the pockets of some very rich people. If we remove a few hundred billion in green energy subsidies, and the Al Gores of the world can't make another $100 million bucks on it, that ought to count as reducing the transfers to the rich just as much as raising their taxes.

Economics cares about the burden of taxation, not who pays taxes. This is clearest for gas taxes. It's clear to everyone that the government is not socking it to those fat-cat gas station owners with gas taxes, they are simply passed on to you and me.

3. Politics (admittedly dangerous speculation for an economist)

What in the heck is going on? Why is our national discussion paralyzed over the tip of an iceberg?

Only one story makes sense to me. President Obama has been saying for four and a half years that he wants to raise taxes on "the rich," and he means to do it. He wants to raise tax rates on the rich, for symbolic, social, political reasons as much as for anything in an economics textbook. Nothing else explains the Administration's monomania on this point, especially given that it won't make a dent in the deficit, the fact that it makes zero economic sense as a central policy to address our economic problems, and given the Administration's refusal to talk about reform -- which would raise tax revenue and help economic growth -- instead.

"The rich," need to get with the program, like Warren Buffet. It remains open season for deductions, exclusions, special deals and loopholes. Notice Buffet never asks for removal of all the clever dodges he uses to pay less taxes, and nobody has mentioned that he might do so. Tax on unrealized capital gains anyone? Limit the exclusion of charitable donations, even to family foundations that employ family members to run them, from estate taxes? Boy, that would raise a lot of revenue from some truly "rich" people.

Quid pro quo here, though, rich people and the CEOs who recently visited the White House had better line up and support the Administration if they want their special deal, deduction, credit, Obamacare waiver, and no visits from the NLRB, EEOC, EPA, consumer financial protection bureau, and so on.

High statutory rates, a Swiss cheese of loopholes renegotiated in every annual crisis, and an army of regulators on the prowl, are a recipe for permanent Democratic government. The cliff is beautifully structured to make Republicans look bad. Things happen when they make sense. This path makes enormous political sense.

The amount of magical thinking on the economic left doesn't help.  They used to claim that that economies like the US in the 1950s can still grow (for a while) despite high marginal tax rates (which nobody paid because of huge deductions). They used to claim that high tax rates wanted for other reasons don't hurt too much. Now they've talked themselves into arguing that high marginal tax rates are actually good for growth.  Why not just say the obvious, this is a policy desired for political reasons, and the political outcome is more important than the economic damage?

4. The future (admittedly dangerous prognostication for one who says things are hard to predict)

The discussion around the cliff  sounds like we are finally settling some large issue. We are not. This is the fiscal molehill, not the fiscal cliff. This is Harpers Ferry, not Gettysburg. It's the Anschluss, not D-day. It's... Ok, I'm overdoing the military analogies, you get the point. This is the prelude to what looks to me like 10 years of constant crisis.

Here is the big issue. The US has already enacted European welfare and regulatory state with American characterstics -- the bloated inefficiency, legalism, and red tape that is our specialty. We have not enacted the taxes to pay for it. We will either dramatically cut back the former, or rather dramatically raise the latter. On the table now is at most $100 billion out of a $1 trillion deficit, and likely much less. The fiscal molehill.

US Federal, State and Local spending is 40% of GDP. Pay attention to state and local, that's a lot more than the 24% Federal we talk about a lot. Europe is more like 50% of GDP, so it sounds like we're behind. But our government is bigger than it looks.

We have about a trillion dollars of "tax expenditures," including the deduction for employer-provided health insurance, deduction for mortgage interest, and (small but annoying) credits for all sorts of things like checks to silicon valley CEOs too subsidize the electric cars they drive down t their private jets. These are no different than a trillion dollars of tax and another trillion dollars of spending, or another 6% of GDP. We're at 46% right here.

Our government likes mandates and rules, which affect behavior and soak up the economy's taxing capacity just as much as on-budget taxing and spending, but hide the fact. Europeans tax gas and energy, and people choose small cars and turn down the heat. We have mileage standards, energy efficiency standards, carpool lanes, electric-car sales mandates, and so on. Same real size of government. And so on.

Before the ACA, our government was paying for health care for about half the country, in our inimitably inefficient style, including medicare, medicaid, schip, and current and retired government employees. Under the ACA, we're basically all in a European style system, funded by explicit or implicit (mandates) taxes. With those uniquely American characteristics.

The fact that government overall is about half of GDP matters to our tax debate. Properly measured, the average American must then pay about half his or her income in taxes. For every dollar taxed at a lower rate, another dollar has to be taxed at a higher rate. When we tax the average dollar at 50%, any progressivity  has to shift a lot of marginal rates well into the territory that destroys incentives and reduces revenue.

Europe pays for this stuff, and its middle class pays for this stuff. 30- 40% payroll taxes, 20% value added tax, $9 a gallon gas, 50% income taxes extending down to what we would call lower-middle-incomes, property taxes, estate taxes, wealth taxes. Sorry, Europe can't quite pay for this stuff, even with those taxes.

But this is our choice. European taxes to pay for the regulatory and welfare state we've already enacted. With the European growth and eventually southern European corruption they entail. Or a sharp cutback in that state. We can decide before or after we experience the European debt crisis.

So, the fiscal cliff is just the beginning. This will be a long hard road, and my guess is that we will lurch from crisis to crisis, with patchwork last minute deals, for another decade. It doesn't have to be so -- the economic choices are clear. But given the size of the question at hand and how little anyone is talking about the real issues, it's hard to see another way.

I think the deck is stacked towards the large-state camp.  There were two theories: "Starve the beast" said, cut taxes and eventually the size of the state will have to shrink. "Vote the benefits" said, increase spending and regulation, and eventually taxes will have to be raised to try to pay for it all. The latter seems to be winning.

I guess it's appropriate that the Grumpy economist is playing the Grinch for Christmas!