What Should be Done about the Fiscal Cliff


Everybody in the media seems to be talking about the fiscal cliff- the likely impact of the expiration of the Bush tax cuts and the planned cuts in government spending that are part of Budget Control Act of 2011. People are right to be concerned about it. Much discussion about the fiscal cliff, and its likely consequences, however, is misleading. The media have emphasized how a tax increase or cut in government spending will reduce overall spending in the economy so that firms have to cut back production and lay workers off. We should be much more concerned about how the fiscal cliff affects investment and entrepreneurship than how it affects aggregate spending.  This is why allowing tax rates to rise, especially on the rich, will do more harm than good. 
Republicans and Democrats claim that they want to reduce the government deficit, which would require some combination of tax increases and government spending cuts. Many are convinced, however, that both the government and families need to spend more to bring the rate of unemployment down. If taxes are increased, households and businesses will reduce their spending. This reduction in private spending, especially if it is combined with a reduction in government spending, may cause a recession.
Although increasing taxes and cutting government spending may have negative short run effects, a more fundamental question is how can the US economy return to a faster long run rate of growth that will make it possible for the millions who are now unemployed to return to work. Contrary to popular belief, the primary reason for the poor performance of the US economy is not that Americans are spending too little. It is rather that businesses are not investing enough in capital equipment and are not willing to hire people because of uncertainty about the future of the economy.  Reducing government spending and borrowing, particularly if the spending cuts are permanent and not temporary, may actually give people greater confidence to invest and start businesses. 
The biggest problem with raising taxes is not that people will spend less.  Higher tax rates influence the incentive to work and invest.  If entrepreneurs and investors expect the government to take 40 cents or more out of every additional dollar they earn, many are going to be less inclined to take the extra risks associated with expanding their businesses and hiring more workers. If, however, the government were to increase its tax revenue by eliminating loopholes in the tax code, the incentive to work and invest would be affected much less than by an increase in tax rates. Certain provisions in the tax code, like the mortgage interest deduction, reward people for doing things that do not help and may actually hinder the long run growth of the economy.  Incentives are the key to a healthy economy, so tax increases are most harmful if they reduce incentives to work and invest, which happens when government requires workers and investors to pay a higher percentage of each dollar earned. 
Why can’t the two sides compromise for the sake of being fiscally responsible- combining moderate tax rate increases with spending cuts?    The debt of the federal government is so large that the token spending cuts being considered by politicians of both parties will do little to prevent government bankruptcy. If the federal government used accounting standards that businesses use, it would count all of its unfunded liabilities, which increase by $11 trillion a year and total more than $200 trillion, as part of the debt. The reported federal government debt excludes trillions of dollars of unfunded Medicare and Social Security benefits that workers expect to receive when they retire in exchange for the taxes they paid during their working years. If a compromise could be reached that involved cuts in promised Social Security and Medicare benefits large enough to make those programs sustainable, it might be worth considering.
A tradeoff exists between short term stimulus of the economy and long term growth. It may be that cutting government spending would slow the growth of the economy in the short run, but that is not a foregone conclusion.  The resulting reduction in government borrowing would mean that more of the money people save would be available to finance private investment.  Increased investment would lead to more and higher paying jobs.  
Continuing to postpone taking steps to drastically reduce government spending, though it may modestly help the economy in the short run, is not the answer. Raising tax rates, however, will do little to address the long run debt problem of the US government and may just make it easier to delay needed spending reductions.  Limiting the share of income taken in taxes and cutting government spending will encourage firms to invest in capital and hire more workers, especially if combined with steps to roll back some of the recent increases in regulation of health care and the financial system, which have contributed so much to uncertainty about the future.

Why the Bush tax cuts should not be allowed to expire

Because I am concerned about fiscal responsibility, I am hesitant to advocate keeping taxes low. Nevertheless, as my colleague Shawn Ritenour emphasized in his blog, restoring fiscal responsibility while also promoting a prosperous economy requires cutting government spending, not raising taxes.

Raising taxes from the current level would have harmful consequences in any case, but those consequences are exacerbated by the fact that we are in a severe recession (some say depression). The main problem with raising tax rates is not that it will lead to a reduction in consumption and demand. If anything it will lead to increased consumption, though by government agencies and recipients of government transfer payments instead of the people who earned the money through their labor.

The more serious problem for the economy is how taxes influence production. When a greater share of each dollar earned is taxed away, it reduces the incentive to earn, whether through working additional hours, hiring more workers, or investing in capital. This problem is more serious for those in higher tax brackets, who are more likely to own businesses and have discretionary time and money that they could invest producing more goods and services. It is not spending that leads to economic prosperity, but greater production of what people value, which depends on entrepreneurs having confidence about the future direction of the economy and an expectation of being rewarded for taking risks. This is the key to an economic recovery that will restore prosperity while preserving freedom.

It is doubtful that raising tax rates on individuals with incomes over $200,000 ($250,000 for married couples), as proposed by the president, would lead to a reduction in tax revenue, but it will not lead to a very big increase. Thus if the big spenders currently in control of Congress really care about fiscal responsibility they will let the lower tax rates on the middle class expire as well. This would lead to an increase in revenue that is at least two or three times as large as from increasing taxes only on the those earning more than $200,000, who make up less than 5 percent of households.

Raising taxes on the middle class may actually have a less harmful effect on economic growth and prosperity in the long run than raising taxes on the wealthy, since work and investment by the middle class is likely less responsive to tax rates than that of the wealthy. Nevertheless, uncertainty about which tax rates will be allowed to increase and which will not also hinders economic recovery. Even if the president and Congress say they do not intend to raise taxes on the middle class, their unwillingness to bring spending under control leaves many of us expecting that Congress might raise those taxes out of fiscal necessity. This uncertainty discourages entrepreneurs from investing in capital to expand production of goods and services demanded by the middle class.

A clear commitment on the part of Congress and the administration to extend the Bush tax cuts across the board would remove some of the uncertainty and lead to greater investment and job creation. While such a commitment is not sufficient to address the looming fiscal problems faced by our government, it would be a step in the right direction.