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How President Obama Can Save Face on the Bush(/Obama) Tax Cuts

January 5th, 2010 . by economistmom

bush-obama-morph

[**NOTE to readers: some updates were added Wed. morning 1/6.**]

It’s the start of a new year, a time when fiscal policy aficionados turn their attention to what the Administration and Congress may have in store for the next fiscal year’s federal budget.  And like a person repenting for their sins of holiday overindulgence (have you been to the gym this week?!), there are a lot of “good intentions” and “new leaf” turning we’ve already started to hear about from the federal budgeteers.

The Wall Street Journal’s Mark Whitehouse reported today on a session at “the” annual conference of economists to be at (I was not)–the meetings of the American Economic Association:

Economists have long fretted about how an aging population and growing health-care costs will cause the U.S. budget deficit and public debt to balloon — an outcome that could wreak financial havoc by undermining confidence in the U.S. dollar. But the latest recession and related stimulus efforts have made the problem more acute, a point four prominent economists made Sunday at the annual meeting of the American Economic Association.

“We’ve moved closer to the precipice, and the precipice has moved closer to us,” Alan Auerbach, an economist at the University of California, Berkeley who has focused on U.S. government finances for about 15 years, said in an interview. The other three panelists at a session on the deficit — Robert Barro and Martin Feldstein of Harvard University, and Tom Sargent of New York University — agreed that the situation is dire. It “frightens all of us,” said Mr. Sargent.

The WSJ story goes on to say that (emphasis added): “[t]he Obama Administration expects the federal budget deficit to add up to more than $10 trillion through 2019, or about 6% of the decade’s gross domestic product.”  (That ten-year average is worse than the end point; it’s 5.0% in 2019.)  That is certainly a troubling figure, because any deficit in excess of about 3-4 percent of GDP is usually considered “unsustainable”–because it implies a debt that would grow faster than the economy is likely to.  But “expects” is a rather misleading choice of word to refer to what is a “Bush Administration policy extended” baseline, making it sound as if the Obama Administration is forecasting the effects of policies set in stone and out of their control–when in fact President Obama is in control now.

In stark contrast to the Obama Administration’s forecast of deficits under “Bush policy extended” is the Congressional Budget Office’s forecast of deficits assuming current law.  Any reader of this blog knows that the CBO baseline is my favorite baseline (near and dear to my heart), not because it corresponds to literal current law, but because it also corresponds to whatever policy changes you want as long as you stick to “pay-as-you-go” discipline–where any tax cuts or spending increases are offset by revenue increases or spending cuts elsewhere in the budget.  Why is this such a real-world relevant interpretation of the current-law baseline?  Because under the CBO baseline, deficits are not 5-6 percent of GDP by the end of the ten-year budget window (or an even more troubling 8-9 percent of GDP with other policy assumptions as in the Concord “plausible baseline”), but are only 3 to 3.5 percent of GDP, which is back down to being at least somewhat believable as an economically “sustainable” level of deficits.

What is the biggest difference between sticking to the CBO baseline versus going all the way to the (awful) Concord “plausible” baseline?  It’s what you do with the expiring tax cuts.  Under the CBO baseline, either the Bush tax cuts expire at the end of 2010 as scheduled under current law, or any portion of them that are extended are offset in cost.  I always (perhaps naively) believed that House Democrats meant it all these years when they passed budget resolutions assuming a CBO-baseline level of revenues as the “right” path for revenues.  It was not until President Obama proposed a budget that assumed extended and deficit-financed Bush tax cuts did House Democrats deviate from this CBO (pay-as-you-go) baseline.

As he prepares his next budget due next month, President Obama has painted himself into a rather sticky corner.  Still living under the curse of his campaign promise to not raise taxes on any households with incomes of less than $250,000, he’s also publicly promised that his next budget will “show us the money” in terms of getting the federal deficit back to a sustainable level–which the President’s own budget director, Peter Orszag, has admitted is not where last year’s budget would take us.  The President’s tax reform advisory board was supposed to release its recommendations last month but delayed its report until sometime early this year–no doubt afraid that they had too little to say given too limited and constrained a charge (improve the tax system without raising taxes on anyone under $250,000, and without raising taxes at all before 2011).

But I think there’s at least one way the President can at least partly have it both ways and “save face.” While I have been a purist on this and still believe the literal CBO baseline path for revenues, assuming a level of revenues consistent with the end of 2010 expiration of the Bush tax cuts, is from a budget perspective the most desirable goal to set for revenue policy, I’m now willing to admit we are probably not going to see this “action-forcing event” actually force fundamental tax reform in time.  Aided by President Obama’s (surprisingly generous) opening bid to permanently extend and deficit finance most of the Bush tax cuts, Congress now works under the assumption that the bulk of the Bush tax cuts will be extended and deficit financed beyond 2010.  So what I see as a possible “save face” “way out” for the President is for him to: (i) modify his next budget proposal to only temporarily extend and deficit-finance the Bush tax cuts that he proposed to permanently extend in his first budget, and (ii) at the same time express his commitment to fiscal responsibility by immediately forming a tax reform advisory board with a real mission and charge to more fundamentally reform the tax system by broadening our income tax base and possibly add additional tax bases such that federal revenues relative to GDP rise (as they will have to) in the most economically efficient way.  That advisory board could make specific recommendations in early 2011, after the midterm elections and while the temporary extension of the bulk of the Bush tax cuts is still in place, giving Congress time to legislate the more fundamental reform over the next year or two.

I see this as a possible compromise between those who wish to follow the policy-extended revenue baseline and those (like me) who much prefer (are obsessed with?) the CBO current-law baseline:  we can cave to the policy-extended baseline temporarily, but we later get back to pay-as-you-go discipline after the temporary extension of the Bush tax cuts is over.  In fact, the President’s new and improved tax reform advisory board could (and should) adopt the CBO revenue baseline from January 2012 on (whenever the temporary extension expires) as their target path for revenues under their proposed reform.  And of course, that advisory board or commission or whatever you’d call it would have to have “real teeth” (and guts), or else the whole thing would become just another punt or worse yet a sham. (I do fear that all our reliance on commissions to get fiscal policy right is going to require a “commission on commissions”–and I’m only halfway joking.)

President Obama would be able to keep his campaign promise to not raise taxes on households with incomes under $250,000, which was essentially a promise to not let the bulk of the Bush tax cuts expire as scheduled.  He would be keeping that promise at least temporarily, and could possibly be interpreted as at least “not reneging” on the promise over the longer run by not allowing an automatic reversion to Clinton-era (pre-2001) tax policy.  [Not that that's at all a bad thing to happen--in fact, it's still my preferred outcome, but I now realize it could only happen in my fantasy world where I am "benevolent dictator"...]  And although fundamental tax reform that involves substantial and badly-needed base broadening is unlikely to not raise taxes on anyone under $250,000, it still is quite likely to raise taxes more for higher-income households than for lower-income ones, because of the way tax exemptions and deductions work (conveying higher subsidy rates to households in higher tax brackets).

The difference between permanently extending and deficit financing the bulk of the Bush tax cuts versus doing so for just one year (for tax year 2011) is staggering in terms of the money saved.  Instead of adding $2 trillion to the ten-year deficit relative to the current-law baseline, a one-year extension would add around $200 billion, up front, almost like another stimulus bill.  Along with the associated savings in interest costs, this could reduce the effect of the Obama budget on the deficit outlook by half.  No other modification to last year’s Obama budget could make as big a dent–because no single proposal in last year’s Obama budget costs as much as the extension of the Bush tax cuts.  (See Table 1-4 on page 6 of CBO’s analysis of the President’s budget.)

The Wall Street Journal article cited earlier mentions the need for fundamental tax reform in the form of adding new tax bases.  While I agree that new taxes such as the (very trendy) value-added tax and a carbon tax would have economic merit and yield badly-needed additional sources of revenue, I think that before we add on new taxes we ought to fix our main tax system, the income tax, first.

And do not misunderstand:  my preoccupation with the tax side of the budget here is only because we’re talking about what the Obama Administration can do right now, in proposing their next budget, to reduce the deficit over the remainder of their term or the next five to ten years (the budget window).  We don’t have a lot of entitlement policy options over this time frame, certainly not politically, but probably not even economically–even if we manage to do the best we can regarding health care reform.  The growth in health care spending is the greatest challenge to the fiscal outlook over the longer term, going out decades from now, and for long term sustainability we’ll have to eventually damp down the growth in entitlement spending and not just raise taxes.  But the greatest obstacle to getting the federal budget deficit back to a “sustainable” level within the Obama Administration’s horizon–be it a term or two in office or a budget window–is the President’s own campaign promise and how it affects what he does with what used to be known as the Bush tax cuts.

I think that politically, the President would not just “save face” but actually “look good” to the American people if he levels with them about the need for real and revenue-raising tax reform as the quickest and surest way to get back to fiscal sustainability, while reassuring them that there will be another round of stimulative, deficit-financed tax cuts to get us through the next two years without any increase in taxes for all but those poor(!) richest of households.

And policy-wise, the President will be doing the right thing in the end if he follows through with the “getting back to fiscal discipline” part with the advisory board’s hopefully more serious and smart recommendations–which ideally would include many components of tax reform that are consistent with other fiscal policy goals.  For example, the current income tax exclusion for employer-provided health care should be scaled back or eliminated for synergy with the goals of health care reform, and tax subsidies for the oil and gas industry scaled back or eliminated for consistency with the goals of environmental policy.

Do I have inside information that this two-pronged approach on the Bush tax cuts is what the Obama Administration is actually planning to propose?  No way.  This is just my crazy little idea and my wildly wishful thinking.  It’s a new year after all, and I’m feeling optimistic.

7 Responses to “How President Obama Can Save Face on the Bush(/Obama) Tax Cuts”

  1. comment number 1 by: AMTbuff

    Letting all the Bush tax cuts expire is one thing, but taking the AMT all the way back to 1993 levels with no adjustment for inflation since then is quite another. Unindexed taxes are simply unfair. A budget baseline that relies on unindexed taxes is illegitimate.

    Index all the parameters of the AMT back to 1993 and the AMT would not be a concern to the middle class. Then do what you want with the tax rates, but at least the tax system will be honest.

  2. comment number 2 by: SteveinCH

    Diane,

    Thanks for a thoughtful post and an interesting idea. To be honest, for it to work, I think the President would probably have to extend through his first term. That would at least be consistent with his “pledge” and better than permanent extension.

    I would however, point out that an overfocus on marginal tax rates is not the best way to evaluate the income tax code. Many people point out that tax rates were much higher pre-Reagan but the change in rates is much more substantial than the change in receipts as a percentage of GDP. The CBO baseline, as I understand it, foresees an increasing percentage of GDP going to the government, indeed a percentage not seen since WWII. I think the substantive policy discussion is around that percentage and only then, the best way to get there.

    While I agree with your focus on taxes, we must also focus on what the President and Congress have done on the spending side. The likely budget for 2011 (even if “frozen”) is likely to be hundreds of billions of dollars above the 2009 budget (excluding tarp). This is all the President’s doing and mitigates any changes on the tax side.

    Furthermore, health care, in my opinion is a net $1 trillion addition to our budget deficit since the “offsets” in both bills are available to the Congress without putting the benefits in. Furthermore, the House bill revenue raisers are largely duplicative with letting the Bush tax cuts expire for the highest income earners.

    Happy New Year to you

  3. comment number 3 by: John Bailey

    To me, the more interesting question is how these deficits are going to be financed?

    Over the last 18 months, the public debt rose around $2.5 trillion, basically financed by the Federal Reserve plus some foreign purchases.

    The Fed is supposedly going to stop buying Treasuries and mortgage backed securities. So how will the $2 trillion that the Democrats project needing (raise in the debt limit) going to be financed?

    My guess is that we don’t need to be worrying about our grandchildren, children, or even 2019. This situation could `happen tomorrow.`

  4. comment number 4 by: economistmom

    Newsflash from today’s NY Times — I swear Peter did not talk with me about this…

    http://www.nytimes.com/2010/01/06/us/politics/06budget.html?ref=us

    With most Bush tax cuts scheduled to expire at the end of this year, some officials, including Mr. Obama’s budget director, Peter R. Orszag, suggested that instead of permanently extending the cuts for all but the richest Americans — as the president has long promised — Mr. Obama could instead propose to extend them a year or two, arguing that further action would await the recommendations of a bipartisan budget commission that leading Senate Democrats want to create.

  5. comment number 5 by: SteveinCH

    *sigh* I wish I could say I was in love with this solution but now we can imagine tax rates going well above the Clinton rates for high earners with all the deduction phase outs that exist. If this is the approach, the baseline for the commission will be the 39.6 and then “fairness” will dictate the rate go higher (since the other rates will need to) and that of course assumes no surtax coming out of health care.

  6. comment number 6 by: AMTbuff

    How about enacting a one-year extension for the entire tax code every year? Then how about we wait until November or December to enact it? That way nobody will know what their taxes will be until it’s too late to change their income!

    Sound silly? It’s what Congress does for the AMT, so why not go all the way?

  7. comment number 7 by: SteveinCH

    To be honest AMT, I don’t think I’d mind that much. I’m not a big fan of tax planning anyway. To me, it’s just so much deadweight loss in our society.

    Yes, it’s tongue in cheek, but I’m not sure what the harm actually is. To be honest, a system that ran one year in arrears would be fine by me as well.

    Imagine if we stopped in Dec of 2009, looked at what we had spent during 2009 and set up the tax system to generate that amount of money. We’d have, in effect, a 1 year debt but that’s a lot less than what we have now.