Commentary | Budget Taxes and Public Investment

Budgeting tradeoffs

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On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (H.R. 4853), a legislative compromise with the blessings of both Republican and Democratic congressional leadership and an $858 billion price tag. The political and economic calculus of the deal was straightforward. The Obama administration and most Congressional Democrats wanted tax cuts for the richest 2% of Americans to expire as scheduled under the (then-current) law and also wanted more fiscal support provided to the economy in 2011 to spur anemic job growth. The Republicans wanted the high-end tax cuts extended and were adamantly opposed to any economic stimulus that resembled the important parts of the American Recovery and Reinvestment Act (ARRA). The compromise actually did satisfy most of these desires: Republicans got two more years of high-end tax cuts, and Democrats got some more economic stimulus for a soft economy, albeit the bulk of it (payroll tax cuts and accelerated depreciation for new investments) in forms that they generally considered less efficient than optimal.

Less than three months later, however, the stimulus provided by the compromise is in danger of being substantially clawed back. The government is on the verge of shutting down because of a Congressional disagreement in nondefense discretionary funding levels for the remaining seven months of this fiscal year. Democrats conceded to a $4 billion discretionary budget cut in a two-week stop-gap funding measure preventing a costly government shutdown. Republicans cite this as a “down payment” on deeper cuts to come, pledging to cut a full $61 billion below funding levels for the first five months of the year.  The White House is now proposing an additional $6.5 billion in spending cuts, moving the starting point for negotiations to about halfway between the president’s budget and the Republican Pledge to America.

Why the sudden pivot away from job creation as the top economic priority and why the implicit abrogation of the tax-cut compromise? What in the political and macroeconomic landscape has changed over the last three months? Where were the objections to markedly increasing the deficit in December and why have they surfaced in February over a much, much smaller sum of money? Has the labor market strengthened sufficiently to justify a move from job-creating to job-destroying economic policies?

While the start of the 112th Congress has substantially changed the balance of political power, the economic outlook is little improved. While it is true that the national unemployment rate has edged down, much of the recent decline can be attributed to continued workforce dropout (the labor participation rate held at a 26-year low in February), and most economists expect the unemployment rate to tick upward in the coming months. Fourth quarter gross domestic product growth has been revised downward from a 3.2% annual rate to 2.8%—barely enough to keep the unemployment rate from rising. It will still be years before unemployment settles back to historically normal levels.

It’s true that the near-term fiscal outlook recently deteriorated—the Congressional Budget Office’s (CBO) January baseline showed a $414 billion increase in the 2011 budget deficit from prior projections in the August 2010 Budget Outlook. But this was no surprise; this is what Congress and the President intended when they approved the tax compromise. Legislative changes accounted for a $409 billion drop in revenue, with another $335 billion added to the 2012 deficit. As for outlays, projected primary spending (excluding debt service) actually fell over the next decade because of legislative changes—the continuing resolution passed in December already cut spending. Total spending—including interest payments—is projected to rise because the tax cuts will require additional borrowing and debt service. Congress knew the price tag of this tax bill and what it would do to the deficit, but it gave the Democrats the job market stimulus that they wanted and gave Republicans the two-more years of tax cuts for the wealthy that they demanded

It is important to remember that the recession and the policy responses to it have led to an expected and needed increase in the federal deficit. Since the start of the recession in December 2007, cumulative budget deficits for 2008-11 have been revised upwards by $4.1 trillion from their pre-recession forecast in August 2007. Of this, $2.8 trillion can be attributed to decreased revenue, most of which is due to the recession and the slow recovery. But a hefty $953 billion of this decline came from legislated tax cuts—the 2008 Economic Stimulus Act, the 2009 American Recovery and Reinvestment Act, and the 2010 tax compromise, among other tax bills.

Removing economic and technical revisions (the non-legislative impact of the recession on the deficit) from the pre-recession forecast of the 2011 budget deficit produces an underlying deficit down to about a two-thirds of its current level ($945 billion compared to $1.48  trillion), meaning that the aftereffects of the recession are still a significant cause of today’s high budget deficits.[1] Then removing the revenue impact of the recent tax compromise yields an entirely manageable $536 billion deficit, or only 3.6% as a share of the economy. Adding back in the middle-class tax relief provisions proposed in the president’s budget and embedded in the tax compromise leaves a budget deficit of roughly $681 billion, or 4.5% of GDP, again a manageable sum.[2]

Solutions to problems should address their causes.  In this case, the recession and repeated tax cuts have blown a hole in the deficit. As a result, solid economic growth and responsible tax policies are the best ways to seriously improve the fiscal outlook. There are 14 million Americans who would be delighted to be taxpayers again, if only we could put them back to work. But this means more spending is necessary in the near-term to support a durable recovery.

By contrast, the budget passed by the Republican-controlled House of Representatives would move economic and fiscal policy in the opposite direction.  This budget would substantially cut public investments, leading to fewer teachers in classrooms, cops on the streets, and workers rebuilding our vital infrastructure. There is a consensus among a wide variety of economists—from those at Goldman Sachs and Moody’s Analytics to those at the Federal Reserve and the Economic Policy Institute—who believe that the Republican budget proposal will result in at least hundreds of thousands of lost jobs. House Speaker John Boehner (R.-Oh.) reacted to this news by casually responding “so be it.”

It is also worth noting that the nondefense discretionary spending now under attack by conservatives is not responsible for the rise of budget deficits in recent years. Between 2008 and 2011, when the cumulative deficits rose by $4.1 trillion, CBO’s estimates for the discretionary budget have been revised upward by only $400 billion, or about 9.9% of the total fiscal deterioration. Most of this increase reflects $311 billion worth of investments in the Recovery Act—investments in transportation, renewable energy, education, food stamps, among others—which are explicitly temporary and will be ramped down (or even better, paid for with new revenue) as the economy improves and which have contributed greatly to the Act’s creation of 3-4 million jobs. So the discretionary budget accounts fo
r less than one-tenth of the fiscal deterioration over the last four years, and most of that increase was a much needed one-time boost during the recession. Yet conservatives want the discretionary budget to bear the lion’s share of deficit reduction efforts.

The Republican position on tax policy makes deficit reduction even more difficult. Remember, revenue losses account for roughly two-thirds of the recent fiscal deterioration, but conservatives have declared tax increases “off the table”—and have even taken to denying basic arithmetic in claiming that tax cuts somehow “cannot” add to the deficit because “they’re just allowing people to keep their own money,” a truly odd non sequitur of an argument.

The bottom line: reckless spending didn’t get us here. What got us here was reckless gambling on Wall Street and policymakers’ failure to rein in these excesses because it would have required confronting politically favored constituencies in the name of protecting America’s working families. Note that none of this is solved by cutting taxes even more, as many conservatives are proposing. 

The issue comes down to a question of priorities.  If we can afford tax cuts for the middle class and the wealthy and corporations offshoring jobs, we can afford to keep teachers in the classroom and cops on the street. Budgeting is about tradeoffs. Trading an estate tax cut for the wealthiest one-quarter of one percent of Americans—a costly provision in the tax compromise—for budget cuts in child nutrition, grants for college tuition, and food safety (all in the Republican budget) is a really bad trade for the middle class. It’s bad for jobs, bad for our kids, bad for our health, and bad for competitiveness. It’s good for inherited wealth and big donors—that’s about it. 

The prevailing sense of Congress seems to believe that deficits don’t matter when it comes to tax cuts for the already privileged, but do matter when it comes to spending. This is job-killing hypocrisy, and a textbook recipe for “starving the beast” and hurting the middle class, not for creating jobs.

[1] CBO estimates a cyclically adjusted budget deficit/surplus reflecting the budget deficit/surplus if the economy were operating at full potential, which takes into account many of the economic factors that have worsened the fiscal outlook since the start of the recession. This measure may underestimate the impact of the financial crisis on the fiscal outlook, however, because the loss of wealth in the stock market decreased actual and projected revenue from capital gains, dividends, and tax-deferred retirement accounts, among other non-economic “technical” factors. Combining CBO’s economic and technical factor revisions to the projected budget deficit offers an alternative measure of the fiscal impact of the financial crisis and Great Recession.  CBO’s August 2007 Budget Outlook (the last before the start of the recession) projected a deficit of $134 billion, unemployment at 4.8%, and core CPI inflation at 2.2% in FY2011, reflecting full-employment. Legislative changes have since added $810 billion to the projected 2011 deficit.

[2] This estimate for the legislative revenue impact of the tax deal components proposed in the president’s budget  reflect alternative minimum tax (AMT) relief and all temporary tax relief provisions less: 1) the 33% and 35% tax brackets; 2) repealing the limitation on itemized deductions and the personal exemption phase-out; and 3) the 0% and 15% structure for capital gains and qualified dividends, all for FY2011 (see the Joint Committee on Taxation’s Estimated Budget Effects Of The “Tax Relief, Unemployment Insurance Reauthorization, And Job Creation Act Of 2010”). The president’s budget proposed repealing the limitation on itemized deductions and the personal exemption phase-out and extending the preferential rates on capital income for individuals earning less than $200,000 and joint-filers earning less than $250,000, so slightly more revenue would be lost (resulting in a bigger deficit) under the president’s budget. This score is used because of data availability issues; JCT’s score of the president’s 2011 budget uses old economic assumptions and JCT has yet to release an estimate of the president’s 2012 budget request.

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