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Don’t Ignore the Cliff, Make It a Better One

October 31st, 2012 . by economistmom

fiscal-cliff-cartoon-darkow-cagle-2012

(Cartoon by John Darkow and Cagle Cartoons, obtained from theweek.com.)

Last week former Senators Pete Domenici (R-NM) and Sam Nunn (D-GA), in the Washington Post, urged policymakers to “build” a “better” fiscal cliff.  As they explain:

Most pundits believe that, rather than go over the cliff, Congress will kick the can down the road during the lame-duck session after Election Day. We suggest that the lame-duck Congress should change the “can” before it is kicked.

Such a strategy has several advantages. First, it could avoid the worst effects of the fiscal cliff without ignoring our fundamental fiscal challenge, the unsustainable mismatch between spending commitments — largely for health-care programs — and current revenue projections. Absent more constructive action, simply postponing when we go over the cliff could hurt business confidence, worry investors and lead to another disruptive debate over raising the debt ceiling.

Second, it is politically achievable. While it is unlikely that a grand bargain to fix the debt could be reached during the lame-duck session, Congress could accomplish replacing the fiscal cliff with broad targets for deficit reduction along the lines of Simpson-Bowles and Domenici-Rivlin, to take effect if no other deal is reached.

Third, this strategy would increase the likelihood of reaching a comprehensive budget deal. If we learned one thing over our many years of service in the Senate, it is that elected officials require political cover on difficult votes.

Enacting such a deal means that Democrats have to be willing to consider reforming — over time — Medicare, a key driver of U.S. deficits. Republicans will have to consider raising revenue through reducing tax expenditures, if not through higher rates. Neither will be an easy vote to cast.

Changing the can before kicking it would allow lawmakers to explain to constituents that, while they don’t like everything in the deal, it is far better than going over the fiscal cliff. In this context, a vote to substitute a rational compromise would be a vote against recession, major tax increases, mindless spending cuts and diminished American influence abroad.

Now, we have set deficit-reduction targets before, but those have merely served as the big “kick me” targets on the fiscal cans that are kicked.  Why would a particular configuration of tough choices, such as Simpson-Bowles or Domenici-Rivlin be adopted when Congress has had trouble enough achieving less-ambitious plans?

If the goal is something as “grand” or “big” as the recommendations of the fiscal commissions, I think there has to be a credible default option that is procedurally easy to implement and enforce.  That’s where I think it’s time we hold our politicians to the laws they have passed in the past–i.e., literal current law with tax cuts that actually expire and spending cuts that actually take effect.  I think of this as the “benign neglect” or “go home” option, because Congress could go (or stay) home and not pass any new tax or spending legislation, and then current law would be forced to literally play out.

The Congressional Budget Office has “scored” this default option time and time again, because it’s called the “current law baseline.” And they’ve noted that although the first year of this current law baseline is known as the (dreaded) “fiscal cliff”–because the around $500 billion of deficit reduction between this year and next is too much for our still-fragile, still-demand-constrained economy to take–the latter half of the current law baseline in the later years of the ten-year budget window gets us to an economically sustainable level of deficits and hence a stronger supply-driven economy.  So CBO has warned (in their outlook report as well as an earlier one specifically dealing with the fiscal cliff) that the first year of current law needs to be avoided, but current law further down the line is a good thing.

The only way to shed the bad but keep the good is to “substitute the can” as Senator Nunn has characterized it during the “Strengthening of America” events that the Concord Coalition co-sponsored.  I’ve called it “recycling” the fiscal cans.  The point is that we can’t just throw the current-law baseline away just because we don’t like the first part of it.  And throwing away scheduled tough choices has become too habitual for our policymakers, because it’s just so easy and so seemingly free.  (Why have to propose future spending cuts or tax increases, when continued deficit financing is an option that finds bipartisan support?)  That’s why I think the public must not allow a mere kicking of the fiscal cans once again; they must pressure our policymakers to simultaneously (at the time of the can kicking) adopt a “tough choices or else” commitment (for policies in the ten-year window) to be set within the next six months to a year where the “or else” part is something even tougher but credible and “easy” to implement.  And what could be easier than current law?

Current law is not a bad “default option”–at all.  At a conference last week at Tulane University, I argued that current tax law (the bulk of what makes current law a huge deviation from “business as usual” current policy) would do pretty well by the three goals the conference dubbed a “fiscal trilemma”–economic growth, deficit reduction, and “progressivity” (the vertical equity of the tax system):

  1. Marginal tax rates certainly tolerable from supply-side perspective, and tax increases not contrary to short-term stimulus if delayed (and given distribution of expiring cuts);
  2. Achieves revenue levels consistent with economically-sustainable deficits over next 10-20 years; and
  3. Increases progressivity of federal tax system (is a pretty good execution of the “Buffett Rule” principle–that millionaires should have average tax burdens exceeding those of middle-income households).

And on a sidenote… I have to confess my huge (and I guess cynical) fear about the currently growing bandwagon of support for “fiscally responsible” policies which I hope does not come true:  that many of the CEOs and politicians clamoring for better leadership to “fix” the “fiscal cliff” issue (or even to “Fix the Debt”) are motivated mostly by their desires to avoid the tax increases and spending cuts comprising the (one-year) fiscal cliff.  “Fiscal responsibility” currently means not allowing our country to go off the cliff, because it could put us back into recession.  But once the immediate can has been kicked to avoid the first-year part of the cliff, and once our economy gets back to full employment, will the enthusiasm to (really) “fix” the debt problem continue, when the time has come when there are no longer the economic excuses to avoid tax increases and spending cuts, but only the obvious, glaring economic reasons to start accepting them?  I do hope so, but I worry, too.

All the more reason for the public to demand not just that we “fix the debt” right now (which could just mean “kick the can”), but that we “fix the debt” even after the election and even after the economy gets back to needing the policy actions formerly known as “fiscally responsible” deficit reduction.

28 Responses to “Don’t Ignore the Cliff, Make It a Better One”

  1. comment number 1 by: SteveinCH

    Wow, so much to object to and so little time.

    First off, the difference in deficits between the current law and current policy baselines are almost all tax increases. Given Diane’s strong preference for higher taxes, it’s not surprising she likes it as a starting point but it’s in no way balanced.

    The current law baseline for FY13-22 has spending in aggregate at $44.3 trillion and taxes at $41.2 trillion.

    How about the current policy baseline? Well you can get a quick sense from summary figure 1 where the tax increase bar is roughly (eyeballing it) 4x the size of the spending cut bar, so something like a 3 or 4 to 1 split.

    But let’s move on to the three points on taxes.

    Marginal tax rates certainly tolerable from supply-side perspective, and tax increases not contrary to short-term stimulus if delayed (and given distribution of expiring cuts);

    So a marginal tax rate of say 50+% should be considered “certainly tolerable?” I guess that’s one way to look at it and as for the phrasing “tax increases not contrary to short-term stimulus if delayed…”, I’ll just say it’s a phrasing worthy of clarification. Tax increases are, by definition, contrary to short term stimulus.

    Achieves revenue levels consistent with economically-sustainable deficits over next 10-20 years; and

    Not sure how this argument is formed. Again, let’s assume there won’t be any spending cuts for the sake of argument. That puts us with something that looks like the President’s budget, the same budget that on a long-term basis doesn’t raise enough money to stave off default. The 10-20 year phrasing is clever. In other words, it allows us to raise enough money until of course, it doesn’t. Then we’ll raise taxes some more.

    Increases progressivity of federal tax system (is a pretty good execution of the “Buffett Rule” principle–that millionaires should have average tax burdens exceeding those of middle-income households).

    Unless I miss my guess, this is way off. Current law includes ending indexing the AMT for inflation. Doing this would be a massive tax increase on the top 10% of the income scale but not so much on the top 1 or .1%. In addition, the Buffett rule only works if capital gains income is materially affected. Current law would raise cap gains by 5 points relative to current policy but still leave it below ordinary income (on a marginal basis).

    But the broader point about capital gains is that the differential is caused not by the differential treatment on income tax but rather by the fact that capital gains are not taxed for FICA. The actual effective tax rate for the “Middle class” if we look at income tax only is already lower than the capital gains rate.

    Finally, federal tax rates were no more or less progressive in 2000 than they are today. Pretty much every CBO distributional analysis reaches this conclusion.

    Now of course, if your intention is to drop a new tax or two on top or change the treatment of capital gains, that’s a different thing. But that, of course, isn’t current law.

    Fiscally responsible deficit reduction is only going to be possible when the left agrees to a hard cap on spending. Until then, no deal is possible. It’s a fools errand to chase ever increasing spending (as a percent of GDP with ever increasing taxes).

    As soon as Diane and others admit that spending as a percentage of GDP should come down as the country gets larger (remember economies of scale anyone), we’ll be ready for a discussion on deficit reduction. Until then, I rather doubt the raise taxes now and we’ll figure out the spending thing later is going to fall on deaf ears.

  2. comment number 2 by: Brooks / Gordon

    Per Domenici and Nunn, “…this strategy would increase the likelihood of reaching a comprehensive budget deal. If we learned one thing over our many years of service in the Senate, it is that elected officials require political cover on difficult votes.”

    Perhaps I’m missing more to their idea, but it seems to me that what they are suggesting is that politicians who won’t support actual legislation imposing some substantial (or “grand”) compromise to reduce deficits may be willing to support legislation with the same compromise as — ostensibly, at least — an automatic trigger if no other deal is enacted to meet a particular target for deficit reduction, presumably because the trigger approach provides them a sort of plausible deniability, so they can say “No, voters, I didn’t vote for that tax increase or those program cuts, I just voted for a mechanism to force Washington to reach a deal for fiscal responsibility.”

    And then, refusing to support any alternative deal because of “unacceptable” sacrifices (ideologically unacceptable, or just politically unpopular sacrifice generally) will be less politically costly — even though it means the automatic sacrifices will be triggered (unless backed off from) — than voting for actual legislation imposing such sacrifices (or anything on that scale that would be politically achievable).

    Have I got it right? Is that the crux of their idea?

  3. comment number 3 by: Arne

    “As soon as Diane and others admit that spending as a percentage of GDP should come down as the country gets larger (remember economies of scale anyone)”

    I believe Diane has already posted on why she does not agree with this assertion. There is no good reason to believe that as the economy grows the mix of private and public good/services would not change.

    “Given Diane’s strong preference for higher taxes, it’s not surprising she likes it as a starting point but it’s in no way balanced.”

    The preference I have read is not for higher taxes, it is for paying for we get. The balance that the 2001 and 2003 tax cuts used was to allow them to sunset. It is at least as reasonable to assume that “balance” is achieved by allowing them to sunset as it is to allow them to continue.

  4. comment number 4 by: SteveinCH

    I believe Diane has already posted on why she does not agree with this assertion. There is no good reason to believe that as the economy grows the mix of private and public good/services would not change.

    And there’s no good reason to believe it should.

    The preference I have read is not for higher taxes, it is for paying for we get.

    Which amounts to the same thing if you want to continue to increase spending.

  5. comment number 5 by: AMTbuff

    Here’s the “Cliff” Notes version:

    The current law baseline incorporates much higher taxes than we have today. Neither party ever intended most of those tax increases to occur.

    Nevertheless, if these tax increases did occur they would allow Democrats to offer to split the difference in a grand bargain with Republicans starting from a higher-revenue status quo. Democrats are starting to salivate at this prospect.

    I favor spending only as much as the voters are willing to pay for. Advocates of large government favor paying for as much spending as the voters want. These two propositions are not the same. The “spend only what you are willing to pay for” formulation naturally results in lower deficits. It’s also how responsible families and businesses operate.

  6. comment number 6 by: Jason Seligman

    A very thought provoking post. I agree that there is a disconnect between short term and long term fiscal prudence, much as there has been since the onset of the financial crisis.

    My sense is that we have before us an opportunity to think holistically about our transition from both the ‘Bush tax cuts’ and the ‘temporary payroll tax relief’ both of which are putting meaningful pressure on Congress as well as the Treasury and the Fed, my sense is a can that was designed to phase out would be a much better default option and one that would be reasonable to endure while the longer term issues impacting our fiscal position are decided upon.

  7. comment number 7 by: Arne

    “Neither party ever intended most of those tax increases to occur.”

    Hyperbole? The AMT is not most of the difference.

    The pre-Bush rates came from increases by Reagan, Bush I, and Clinton to counteract the overshoot when Reagan cut rates. They ended up near the point where we willingly paid for what we wanted. Bush sold the tax decreases on the basis that we did not really need the revenue - not that we did not want the programs. Now that Bush II has been proven wrong, we need to go back to paying for what we want.

    The two huge caveats are that (at the current rate of growth with respect to GDP) spending on healthcare is unsustainable and that we are still in a downturn which will respond to stimulus (or anti-stimulus).

    Right now the short term need for stimulus should trump the long term need to do more than simply allow the 2001 and 2003 tax cuts to sunset.

  8. comment number 8 by: SteveinCH

    Right now the short term need for stimulus should trump the long term need to do more than simply allow the 2001 and 2003 tax cuts to sunset.

    How fast would the economy need to be growing before there would not be a “short term need for stimulus?”

  9. comment number 9 by: Vivian Darkbloom

    “Neither party ever intended most of those tax increases to occur.”

    The only possible quibble one could have with this would be the use of the past tense “intended”. This seems much closer to fact that fiction.

    If current intentions match the intentions the moment after those “Bush tax cuts” were enacted, that statement would certainly be correct.

    Here’s what I see:

    The Republicans never intended those tax increases to occur (i.e., for the tax cuts not to be extended). They always intended the cuts to be extended. I doubt there is any serious dispute about that.

    The current Democratic stance is that only those tax cuts for high income earners should not be extended, but everything else should be (plus some other cuts that have been enacted in the meantime). I’ve never heard any argument from the D Team that the extension for everyone else should be temporary, much less as temporary stimulus.

    While Obama seems to favor extending (permanently) tax cuts for those earning less than $250K, many other Democrats would increase this to $1 million.

    Taking the more conservative $250K number, the CBO in its August 2012 report estimates the 10 year cost of extending all expiring tax cuts (including estate tax cuts and indexing AMT) to be $4,532 billion. The revenue cost of not extending the estate tax cut and the tax cut for those earning $250 K and above is $3,708 billion.

    http://www.cbo.gov/sites/default/files/cbofiles/attachments/08-22-2012-Update_to_Outlook.pdf

    (See p. 19)

    As I see it, neither party intends “most” of those tax increases to occur. As for the D’s, I just wonder at which point in time in the past they decided to be against $3,708 billion of $4,532 in tax increases that would result if those tax cuts expire?

    Of course, I could be wrong. If I am, there are 5 days left before the election for someone high up on the D Team to correct me and state that yes, they’re not for extending those tax cuts or, that they are for extending them, but only temporarily. If that is the real agenda, I’d say this is the appropriate time to say so.

  10. comment number 10 by: Arne

    How fast would the economy need to be growing before there would not be a “short term need for stimulus?”

    My understanding would be that with unemployment near 8 percent we should have GDP growth well over 4 percent.

  11. comment number 11 by: Arne

    Until Obama came along with his idiotic promise to not raise taxes on those making less than $250K, I think a lot of folks who saw that Bush got it wrong were relieved that the taxes would sunset. Unfortunately, Congress critters feel compelled to follow the leader.

    AMT and Vivian may be right about intentions of both Rs and Ds, but since Congress during all three presidents before Bush II raised taxes, I suspect that most thought they could raise taxes again if revenue decreased too much.

  12. comment number 12 by: ST Dog

    Arne,

    I’m not clear where Bush “got it wrong”
    Please explain.

    Counting “war spending”, Bush had deficits of: 2.0%of GDP from ‘01-’08. Add in TARP for ‘09, and Bush deficits are 3.4% of GDP. Both are below the 4.2% of GDP of Regan and Bush from 1981-1993.

    I think war spending was far lower than it should have been. The only mistake I see was not implementing “war tax” to fund the war. But it needed to stay “off budget” like the war spending.

    Meanwhile Obama has given us 8.7% of GDP (’10-12).

  13. comment number 13 by: Arne

    Surplus or Deficit (–)
    2001 -0.3
    2002 -3.0
    2003 -4.9
    2004 -4.9
    2005 -4.0
    2006 -3.3
    2007 -2.5
    2008 -4.5
    Unsustainable budget deficits even though tax receipts were elevated by the housing boom.

    Obama has given us large deficits because those receipts dropped.

    It was obvious at the time that Clinton was riding a bubble (”irrational exuberance”). Only some people called the housing bubble before it popped, but it should be obvious now that Bush was also rising a bubble. He should have been running a surplus from 2003 on.

  14. comment number 14 by: SteveinCH

    Hey Arne,

    I have no idea where you pulled those numbers from but they are just wrong.

    From the CBO (link below),

    2001 1.3
    2002 -1.5
    2003 -3.4
    2004 -3.5
    2005 -2.6
    2006 -1.9
    2007 -1.2
    2008 -3.2

    And because you conveniently omitted the Obama years

    2009 -10.0
    2010 -8.9

    As for your contention that Obama has given us large deficits because those receipts dropped, it’s also false.

    Over the 8 years from 2001 to 2009, spending averaged about 19.5% of GDP. Today it’s nearly 24% of GDP. It’s kind of hard to figure out how that is caused by “tax receipts elevated by the housing boom.”

    So I’d suggest you recheck your facts before you make silly posts.

    http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/120xx/doc12039/historicaltables1.pdf

  15. comment number 15 by: Brooks / Gordon

    Steve,

    It seems you’re making a valid criticism of Arne’s attribution of Obama’s larger deficits simply to a decline in revenues, given the increase in spending as percent of GDP that you note. But it’s also worth noting that the decline in revenues as a percent of GDP revenues has also been a significant factor: revenues 2009 through 2011 have been a bit over 3 percentage points (of GDP) lower vs. 2006 and 2007.*

    Spending (”Outlays”) were about 20% in 2006 and 2007 (and between 19 and 20% from 2002 - 2005) and then about 25% in 2009 (up about 5 points) and about 24% in 2010 and 2011 (up about 4 points).

    So, at least vs. the last two pre-crisis/recession years, spending accounted for more of the increase in deficits as percent of GDP than did revenue decline as percent of GDP, but both contributed substantially.

    By the way, it seems Arne’s figures are for On-Budget deficits, not net of Social Security surpluses (i.e., unified budget), so in my opinion he was using the less appropriate metric and you are using the more appropriate one.

    Also, your link didn’t work for me. I got the Excel at http://www.cbo.gov/publication/42911

    * Revenues were about 16% in 2003 and 2004, when “Bush” deficits were highest.

  16. comment number 16 by: Steveinch

    The issue Brooks is that the decline in revenue is temporary even with no change in the current rate code while the increase in spending is not.

    Under current policy,revenues recover to 18.5 percent by the end of the decade. It’s also worth noting that revenues would be 0.6 percent higher today but for the payroll tax holiday

  17. comment number 17 by: Brooks / Gordon

    Steve,

    Actually, I think what you and I were addressing was Arne’s attribution of the increase in deficits under Obama (vs. Bush) to a decline in revenues.

    But if you wish to pivot to a broader matter, what point are you making?

  18. comment number 18 by: SteveinCH

    My point Brooks is that the decline in revenues is a temporary macro effect much more so than is the increase in spending.

  19. comment number 19 by: Brooks / Gordon

    If someone could please do me a favor and clarify something for me:

    Would the fiscal cliff Defense cuts be separate and in addition to whatever decline in Defense spending Obama plans, driven I assume by decline in war spending?

    I recall warnings that the fiscal cliff cuts would be “devastating” to our national security or something to that effect, so I’m wondering if those cuts would be redundant with reductions in spending Obama already plans (and/or is already projected) as war spending is expected to decline, or if the fiscal cliff cuts would be in addition.

  20. comment number 20 by: Brooks / Gordon

    Steve,

    Yeah, I realize you said that. I’m asking you if you are offering that premise to make some point. If I accept your premise, arguendo, are you implying some point that you wish to make?

  21. comment number 21 by: Brooks / Gordon

    …Steve, is your point that Obama-era increases in spending will be the lion’s share of the cause of high deficits you expect over next several years (much more so even than over than 2009-2011), with lower revenues (vs. the Bush years, or the last couple of pre-recession years) being a relatively insignificant factor?

  22. comment number 22 by: Arne

    Steve,

    I left out the Obama numbers because ST Dog responded to my comment about Bush with numbers I dispute. Beside the fact that I disagree with Brooks about which column of numbers is generally more appropriate, the balance of ST Dog’s comment make on-budget the clearly appropriate set.

    Of course bubbles increase tax receipts. Over a 30 year timeframe capital gains has contributed as little as 5 percent and as much as 15 percent of revenue. This volatility was key to Clinton’s surpluses. It was also present during Bush’s second term. In 2008 revenue dropped both because of the bubble bursting and because of loss of employment.

    The bulk of the spending increase is also caused by loss of employment and is magnified if you report it as a percentage of GDP. While you are certainly correct that they contribute to the deficit, I do not accept your premise that they are not temporary.

    The persistent macro effect you observe is underlying. Healthcare costs are growing faster than GDP (or revenue) independent of the one-time effect of sunsetting the 2001 and 2003 tax cuts.

    As I originally stated, Bush was wrong to sell the cuts on the basis of not needing the revenue.

  23. comment number 23 by: Brooks / Gordon

    Arne,

    Re: The bulk of the spending increase is also caused by loss of employment and is magnified if you report it as a percentage of GDP.

    I’ll leave aside your claim re: unemployment causing the bulk of the spending increase (which is too vague to respond to anyway, since that could be interpreted broadly as any spending intended to generate jobs), and instead I’ll just comment re: the “magnified” part re: GDP. I don’t think it’s magnified much. If a denominator is, say, 1% or 2% lower than under some other scenario, the fraction doesn’t become much greater. Not much difference (for purposes of this discussion) between 25/100 and 25/99 or 25/98.

  24. comment number 24 by: SteveinCH

    Arne,

    The fact that you think “off budget” revenue and costs should be ignored is interesting. Puts you out on an island and makes you look like a partisan but it’s interesting.

    As to your point on capital gains volatility affecting receipts in the Bush administration, sure it’s true but I’m not sure why it’s relevant. Cap gains receipts are always volatile.

    As to “the bulk of the spending increase is also caused by loss of employment, you are simply incorrect.”

    To take a simple example, let’s compare the budget in 2010 to the budget in 2007. Most of the spending caused by unemployment shows up in income support (UI and TANF are here). Income security as a percent of GDP was 1.5 percentage points higher than in 2007. Meanwhile, total spending grew by 4.2 percentage points. So, unless “the bulk of” in your view is less than 40 percent, I’d have to say you are wrong.

    As to your point on revenue, a budget that works off of relevant inflation plus population growth by major category and assumes 1% annual efficiency improvements requires total spending increases of less than 3%. Not that anyone on your side of the argument would ever be willing to live with that of course…

  25. comment number 25 by: Arne

    “Puts you out on an island”
    The same “island” as the folks who were claiming that Clinton never really balanced the budget because he depended on the SS surplus.

  26. comment number 26 by: Brooks / Gordon

    Arne,

    The same “island” as the folks who were claiming that Clinton never really balanced the budget because he depended on the SS surplus.

    Yes, it puts you in the same company (analytically speaking) as those folks.

  27. comment number 27 by: SteveinCH

    Arne,

    Yes. The same island. They are wrong and so are you.

  28. comment number 28 by: Arne

    Since this thread is not closed yet I guess I get to share some of the data I have looked up.

    If the purpose is to answer whether deficits are within sustainable limits, then including the Social Security surplus as income was clearly a poor analytical choice. Nonetheless, when people discuss the budget they generally are talking about the unified budget, so I will follow suit.

    “If a denominator is, say, 1% or 2% lower than under some other scenario, the fraction doesn’t become much greater.”
    True, but GDP is 9 percent lower (for 2010) than it was projected to be in 2007. Nonetheless, reporters do not correct for this, so I will again follow suit.

    “Most of the spending caused by unemployment shows up in income support”

    While this assumption may sound correct at first, a look at the data shows that it is not.
    The mandatory expenditures on “Income Support” did increase by 1.5 percent of GDP. (2007 to 2010) On top of that, SS costs increased by 0.7 percent, Medicaid by 0.5 percent, Medicare by 0.5 percent. (Demographics accounts for about 0.1 percent per year for SS and Medicare, so the total of these is 3.2-0.6 caused by loss of employment.) Total mandatory expenditures increased by 2.8 percent (with “other” actually decreasing by 0.5). Discretionary spending is also up by 1.9 percent of which ARRA spending was 1.6 percent of GDP in 2010.
    With apologies for rounding (and ignoring columns such as receipts counted as negative expenses), total expenditures were up by 4.7 percent of GDP of which 3.2 percent, 70 percent, certainly the bulk, was caused by loss of employment.