December 28, 2012

A Guide to the Fiscal Cliff Debate

By: Luca Gattoni-Celli

As $136 billion in spending cuts and $532 billion in tax increases loom ever larger with the approach of January, the policy debate surrounding the fiscal cliff has settled around a few key points, among them the necessity of a “balanced approach” to deficit reduction. According to progressives including President Obama, this would entail raising taxes on those making over $250,000 annually. Both Republicans and Democrats have proffered specific visions and general policy outlines for how to reduce the Federal deficit and address the national debt. And both have consistently rejected what the other has to offer, though all concerned oppose tax increases for the politically important middle class.

Taxes exert a cost on economic activity, making whatever they are applied to more expensive and less attractive to pursue. This applies to earning income, the direct counterpart to activities which generate economic value for society through the system of economic exchange collectively known as the market. Activity foregone due to taxation is called deadweight loss. The pivotal question is whether the deadweight loss created by a rate increase on top income earners is a worthwhile tradeoff for deficit reduction. In so many words, will the tax rate increase cut the deficit enough to justify its economic costs?

As the above chart illustrates, the high earners being discussed pay a disproportionate share of income taxes. Mitt Romney’s infamous “47%” comment referred to the estimated proportion of Americans who pay no income taxes, some of whom are net-recipients of public funds. The debate over taxing higher-income people turns out to be salient. Taxes they pay disproportionately impact revenue overall.

Having framed the discussion, we can now consider the key metric: Federal income tax receipts have recently ranged between 10.2% in 2000 and 6.3% in 2010. (Only the 1944 peak of 9.4% approaches the 2000 high, as the above chart illustrates.) The casual, uninformed observer may find the narrowness of this range and modesty of its upper bound surprising. By contrast, government spending as a proportion of GDP stood just above 40% in 2010 data for and projections for 2011 and 2012, and is projected to dip just below 40% next year. The same Office of Management and Budget figures show that total Federal tax receipts have only ever exceeded 20% of GDP in three years: 1994, 1945, and 2000. This is despite substantial variations in policy and economic conditions over the last eight decades.

In short, government comprises a sizable chunk of economic activity as measured by gross domestic product. Income taxes make up roughly half, maybe a little less, of tax revenue at any given time, and also roughly match trends in general tax revenue over time. Tax revenue appears to be limited to a natural ceiling around 20%, though the 2000 peak preceded significant tax cuts which reduced revenue in the short term, and well could have continued to rise before the 2001 recession. On the ‘other other hand,’ revenue began growing again at a steady clip before the Great Recession began; supply-side policies do not always reduce tax revenue. Historical data generally show that income tax revenue is most reliably tied to economic growth, as illustrated by the presidencies of Ronald Reagan, Bill Clinton, and George W. Bush.

It would be easy at this juncture to make a sweeping policy recommendation based on specific assumptions about the effects of spending and tax increases and decreases on deficits and economic activity, to say nothing of the effects the latter two exert on each other. However, an exposition of these myriad assumptions’ implications is more honest, constructive, and inclusive.

Those who value economic growth above all else — and basically accept that taxes negatively affect the economy — will be wary of increasing them on anyone, especially given persistent weakness in the labor market. As prominent economist and public intellectual Walter Williams pointed out last year, garnishing every cent wealthy individuals earn would not address deficit spending, even assuming no negative repercussions. Williams’ observation lends credence to Arthur Laffer and Stephen Moore’s supply-side economic perspective. Free market apologists also worry about the crowding out effect of government borrowing, the phenomenon by which Treasury bond sales deprive private borrowers of capital. Thus, they would advocate general tax cuts and even larger cuts to spending and government bureaucracy to free up the private economy and reduce deficits.

Supply-siders offer an intuitive position, but there is a compelling counterview backed by reams of sophisticated mathematical theory. Those taking John Maynard Keynes’ work at face value are skeptical of supply-siders’ arguments, pointing out that money – which, in their worldview, drives private economic activity through the mechanism of consumption – tends to be hoarded in down times by individuals unwilling to spend and banks unwilling to lend. Much of this trepidation is in anticipation of recovery which is, ironically, restrained by hesitancy and doubt — a catch-22 predating Joseph Heller’s classic novel which originated the term. When Keynes said, “in the long run, we’re all dead,” he was expressing a need for government to ‘prime the pump’ of economic activity.

Therefore, Keynesians would advocate tax increases on the wealthy (who under normal circumstances spend a small proportion of most of the dollars they take in) and limited, gradual spending decreases to address towering deficits in an uncertain economy.

Keynesian extremists advocate positions Keynes himself would have questioned even at his most bombastic and radical. Paul Krugman is the most notable example; he has responded to the fracas surrounding the fiscal cliff by arguing that debt is a long-term concern at worst, and not a problem at all by any reasonable standard. His prescription for a lagging economy is a flood of stimulus spending. Taxes have a less depressive effect than spending decreases in his view, so he would see no problem with increasing taxes on the wealthy, particularly if doing so promotes economic equality and makes allows government to spend money that would otherwise lie idle. Keynes’ General Theory book of macroeconomic ideas, on the other hand, advocated a counter-cyclical fiscal policy of zero debt in the long run.

Whichever views various policymakers hold (consciously or otherwise), it is useful to understand where they are coming from, especially for those directly involved in these deliberations which have such great implications for our economy and society, and those of the entire world.

Luca Gattoni-Celli is a writer based in the Washington D.C. area. Image courtesy of Big Stock Photo.

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