Talking Them Down from the Cliff

Oftentimes when I see a great cliff giving a precipitous drop down to the sea, I am surprised to see people down by the water bathing or sunning in privacy--think of the Amalfi coast, or Big Sur, Hawaii, or Cabo.  It turns out that there was a way down from the heights, after all--without jumping or falling. It just takes clear eyesight and the patience to work one's way down.

When the deal was made some 16 months ago which led ultimately to the current Federal government predicament, in which major tax increases and substantial, rather indiscriminate cuts in spending will occur unless there is some legislative remedy, I was not one of those who was particularly critical of  President Obama for making the deal.  I didn't remember being that harsh on the deal itself (though now that I re-read the post, I gave it a D-) .  I anticipated that there would be no intervening agreement, that it would indeed come to this, but I didn't think the automatic spending cuts and tax increases it stipulated as the default, should there be no future agreement, would be that harmful--it would at least address the growing debt problem.

Now, though, it is clear that austerity is not the right solution for the country at this time.  There is a recovery, somewhat fragile, that could be snuffed out by tax increases and spending cuts.  There is the example of Europe, for which the austerity programs have brought only increased strife and recession, or at least the expectation  of it. So, it is still appropriate to put off the tax cuts for a while yet again. I think that will be the part of a package to set fiscal policy for upcoming years that should be the easiest to approve.

Just when the tax cuts should end, and which should end sooner--that's the hard part. Obama laid down his marker today--just give me the extension of the tax cut for the middle class and I will sign it--and Speaker Boehner has laid down his:  no tax increase for "small businesses" (read:  high-income taxpayers),  no "delinking" of the tax cuts between the middle class ones and the high-income ones. Obama claims that the voters ratified his policy of higher taxes for the wealthy, but not for the middle class; Boehner claims the voters returned his House majority for no tax increase for "job creators".

For any deal, Obama will need to thread the needle:  pull together the Democrats, get a few Republican Senators to go along (it would be too much to try to get Minority Leader Mitch McConnell to agree to anything--he is watching his back for 2014 and will hold a hard line), and get Speaker John Boehner and enough Republican Representatives to ensure passage.  The last will be the hardest part, as Boehner will have to tread a fine line between what can be agreed and what will undermine his leadership of his party's caucus.

There are two strategies Obama could use to try to resolve the impasse.  The power play would be to insist on ending the tax cuts for the wealthy and preserving those for those less wealthy, going to the public to get support for his position. It wouldn't happen quickly, though:  Obama would have to be willing to play to the brink, and let tax cuts end in January.  Then, when the pain is visible throughout America in the reductions in take-home pay, if Obama has played his cards right, the outcry would force the Republicans to give ground. The finesse play is to maintain the tax rates, allow the payroll tax cuts to phase out over time, but try to achieve the necessary revenue increases through elimination of tax-favored income (such as capital gains, dividends, and the carry interest) and reducing deductions for upper-income taxpayers. 

The latter approach is the one that will be more readily acceptable to Republicans in Congress, but it will be difficult to achieve the revenue increases that are needed for the "balanced approach" on which Obama will insist (roughly, $1 trillion over ten years, starting small and growing over time) purely through these methods.  Also, there is a legitimate question whether increasing taxes on some of these investment-oriented "tax expenditures" like capital gains and dividends, or maintaining corporate tax rates at their current high level would be a healthy thing for the economy.  For this reason, I would tend to go the other way, and urge the gradual relaxation of the tax cuts (increase in tax rates), even for the "middle class", but on different schedules for the wealthiest (over $1 million income), the upper-income, and the middle class. If Obama can achieve some agreement on this approach in the next two months, without going over the edge, it will be a huge victory for all.

Some deductions that serve no policy purpose (such as for the expenses of moving jobs overseas, a poster child for the need for tax reforms) and loopholes set up for a privileged few should be phased out or eliminated, but most deductions are there for a good reason and should be preserved.  The mortgage interest deduction is not so well justified, but it will be impossible, and inadvisable given the beginning of recovery for the housing market, to do more than cut it a little around the edges (cap on the deductible interest, gradual reduction of the deduction for second homes, etc.) I am not in favor of any approach that tries to solve the problem by adding to the tax burden on the lower classes, such as a VAT or flatter tax.  As for the end of the payroll tax reduction, that could be preserved through finesse, by eliminating the cap on the payroll tax for Social Security, which currently kicks in the low six-digit incomes. 

Once the question of who gets gored when with additional taxes, the rest of the deal is not so hard to describe.  The "sequestration" cuts across the board in social programs and defense will be replaced with specific cuts that can be identified and worked out.  The big "entitlement programs"--Medicare, Medicaid, and Social Security--can have cost improvements identified, but it will take years, not months, to work out how those would occur.  The outlines of this deal can and should be worked out now, with the lame duck Congress, though many details will be sorted out in the next Congress.  The key things for now are:  agreement on the 3-to-1 cuts to revenue ratio, the dates when revenue increases will come, agreement on the debt ceiling for the next year or so, and agreement on the distribution of targeted cuts by department.

I am optimistic that some progress will be made over the next few weeks, and I am pulling for Speaker Boehner to succeed in his difficult task:  if he gives too many accommodations to the Democrats, the Republican rank-and-file will overthrow him, and the resulting leadership (Eric Cantor & Paul Ryan), who are more than willing to take him down, would renew the impasse.  For this reason, I think Obama should go slowly in attacking the Republicans, and the progressives who pushed Obama over the top once again this year should be patient--at least until it is clear that the "good cop" approach can not succeed.