Assessing the Cliff Fallout

Everyone has his take on the legislation that emanated from the fiscal cliff “negotiations.”  Here is mine.

First, I see a lot of over-analysis and over-judgment. There are grounds on which to give the various pieces extreme grades. But the clearest conclusion of all is that this game ain’t over.  Saying that there is too much in tax increases relative to the spending cuts (or vice versa) is a little like dissing the sausage before all the scraps are ground, much less stuffed into the casing. We know that there will be at least two more rounds. March Madness will bring the expirations of the postponement of the sequester and of the continuing resolution appropriating funds for federal agencies, plus the exhaustion of the Treasury Secretary’s “extraordinary measures” to get around the debt limit.  And because the Congress and the President cannot possibly solve the big problem in these two short work months, there will be at least one more round after that.  There will be more bites at the sausage, as unappetizing as it may be.

Even the complaints that this is not the “big deal” that puts the problem to rest seem a bit contrived.  Every informed Washington watcher saw that coming a year ago.  Likewise with complaints that some of the money-losing provisions of the package are not “paid for.”  If further rounds of this budget marathon stop the debt from growing faster than our economy – thereby capping the “debt-to-GDP ratio” – then every provision of this and previous pieces of legislation will be paid for enough.  If later rounds do not meet that standard, then paying for the small money-losing pieces in this recent bill would have fallen far short anyway.  It is not yet time for final judgments, only for explicitly incremental calls.

So we should judge this package by standards that it possibly could have met.  Of course, even grading on a reasonable curve, this one isn’t going to get honors by a long shot.

Let’s skip the obvious – the deal did obviate the worst of the fiscal cliff, and it did fall short as a budget remedy – and get to a couple of important but less-widely-recognized points.

The best thing that you can say for this deal is that it did get the individual alternative minimum tax (AMT) off of our backs, essentially permanently.  The AMT had mutated from a device to catch manipulators of abusive tax shelters into a trap for innocent large families in high-tax states (because it does not include personal exemptions for additional family members, does not allow a deduction for state and local taxes, and is not indexed for inflation).  I remember with frustration the negotiations over the 1997 balanced budget legislation (which, truth be told, cost the budget money in 1998, the first year in which the budget in fact was balanced).  Once it became clear that the budget was in much better shape than had been anticipated, the two negotiating parties agreed to establish a “kitty,” which they split 50-50 between them, for added spending or tax cuts.  But neither party was willing to spend its money to fix the AMT, because each recognized that it would earn no political reward for solving a problem that few voters knew they had.  The fiscal cliff bill does permanently index the AMT for inflation.  At some future hour, failing fundamental reform that replaces the AMT entirely, real economic growth will make the AMT an unacceptably intrusive factor again.  But we have earned a breather at least until then.

OK, that’s the good news.  Now for the rest of the picture.

Sure, the tax revenue increase is based on higher tax rates rather than base-broadening reform.  But again, it was easy to see that coming in the inevitable post-election-day rush.  If there is a silver lining in that blunt remedy, it is that it gives somewhat more flexibility in a hoped-for future attempt at genuine reform.  Everyone tells the pollsters that he or she would be willing to pay more in tax in exchange for a simpler tax system with fewer unfair (and economically distorting) loopholes.  Everyone lies.  The first question you hear about any tax-reform tradeoff, with fewer deductions offset by lower rates, is “Will I have to pay more?”  Starting from a tax system that collects higher revenues will make the ultimate winners-losers calculus of any future reform look a little less bad.  (But it will be bad, because at the end of the day it will take plenty of painful choices to solve the very big budget problem that we already have.)

A second look at the tax provisions in the new law shows that in other respects, however, things came out backwards.  There is a little bit of folklore in the social sciences community about a wise old professor who stood up at a conference to comment on a much younger colleague’s paper.  The old professor decided to be frank, and so he began, “There is much that is new and interesting in this paper.  However, what is interesting is not new, and what is new is not interesting.”  Well, in the fiscal cliff bill, many tax provisions that you might hope would be temporary are permanent, and others that might best be permanent are temporary.

A long list of previously temporary tax cut provisions – such as tax benefits for college expenses, and middle-class oriented tax cuts – are now a part of permanent law.  Once we start to get serious about attacking the rising public debt, and therefore find that we must raise taxes on more than the highest-income swath of society, some of those tax cut provisions will need to be reviewed.  Having them as permanent rather than temporary law will make that review just a little bit more difficult.  Having the college tax benefits as permanent may be particularly troublesome, because they are both complex and arguably poorly targeted.  Even apart from the need for deficit reduction, some education economists would argue that the entire financial aid system – including the tax subsidies – should be redesigned to target more students who cannot now afford to attend.

On the other side, many so-called “extenders” – temporary tax cuts, generally for businesses – were “extended” for only one year.  Among these provisions are the “loopholes” – the benefits for NASCAR track owners, movie producers and so on – which have been decried in the press.  Looking beyond the questionable merits (more on that in a moment), carrying these “extenders” year by year raises all sorts of issues.  Some cynics say that these provisions are made temporary to force the enactment of a tax bill every year.  (Remember that the Constitution requires that revenue bills originate in the House, which means that tax provisions cannot be tacked on to other bills in mid-process or in the Senate if desired.)  Having these extenders in need of annual renewal means that a tax-bill “train” must leave the station at some point, opening up seats for other tax-provision “riders” that could not motivate an entire tax bill on their own.  Some of the more cynical of those cynics would go further and say that having a robust list of “extenders” in need of action also creates an address list of interests that will be willing to make campaign contributions to see their provisions through to re-enactment.  Good governance, as distinct perhaps from good policy, would dictate that each of these extenders either be made permanent or be allowed to expire, once and for all.

But to cast perhaps a slightly more optimistic tint on the prospects for those offensive extenders:  The Senate Finance Committee held a “review” of alleged tax “loopholes” in the previous Congress.  The session was reportedly painful, with advocates of the provisions under examination visibly embarrassed to state their cases.  However, in the end the Committee accomplished very little, because the Senators had a hard time singling out for repeal any individual provision.  Why should my constituent’s alleged “loophole” be repealed, each Senator said, when all of the other arguably equally unjustified provisions survive?  And there is another sometimes-effective defense of tax loopholes:  With tax rates as high as they are, my constituent needs some protection, or else jobs will be lost, good-faith investments will be rendered less valuable, and so on.

One reported reaction to the recent Senate Finance review echoed the experience of the enactment of the Tax Reform Act of 1986:  When numerous targeted tax provisions are on the chopping block together, and when tax rates will be reduced at least somewhat through the reform process at the end of the day – and the more loopholes repealed, the lower the tax rates – the hurdle that such provisions must surmount to justify their places in the tax code becomes significantly higher.  It took each chamber of the Congress some time to find its way to accept this logic in 1986, but in the end, there was enormous progress.  The same could happen now, if we come to serious reform as an imperative.

In sum, the resolution of the New Year’s cliff was hardly a cause for merriment.  But it never was expected to be, at least by those who understand how Washington works.  Nor is it necessarily reason to become any less optimistic for the future – if that were possible.  There still is nothing in recent behavior to suggest that the two warring political factions will come to a satisfactory deal.  We still must work to change Washington behavior in a quantum way, or else this debt mire will only deepen.  But the New Year’s experience adds precious little information to that calculus.  The prospects are no better, but neither are they any worse.

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