The President and Congress may throw America into another recession, thanks to the Balanced Budget Act, which was crafted so as to punish the entire country with brutal spending cuts and tax increases if politicians couldn’t agree amongst themselves on a kinder, gentler plan to tame the deficit. It seems, at first glance, like the mother of all incentives: without an agreement by January 1, fiscal shock and awe will slash, among other things, defense spending and Medicare payments to doctors, and keep slashing for the next decade. At the same time, America will have to go cold turkey on Bush-era tax cuts, resulting in a combined hit to the economy in the order of $500-billion in 2013 and $682-billion in 2014, according to the Congressional Budget Office.
But even as economists predict surging unemployment and recession, the issue is whether Washington D.C.’s Hatfield’s and McCoy’s can possibly concede enough ground to reach an agreement before they end up hitting the ground together – and taking us with them. And this epic game of chicken has invested the federal budget with the breathless allure of a political battle. Will there be bipartisan glory, where each side emerges bruised but with a common victory? Or will there just be round after round of vainglorious partisan vitriol that ensures mutual defeat? The media have ringside seats, the stakes are huge, and the blow-by-blow commentary is intense. Never has the Federal Budget, the unwitting star in this fiscal war, gotten so much attention.
Except, in a fundamental sense, it hasn’t.
Let’s step back, so to speak, and ask why we are on the precipice of a fiscal cliff to begin with? The problem, arguably, starts with the wrong choice of image. If you want to understand why the United States is in fiscal trouble, it is far better to think of all of us being in a very, very big hole – the collective equivalent of a $16-trillion dollar credit card balance.
Proponents of higher taxes, typically Democrats, believe that raising tax rates will make this hole substantially smaller, while proponents of spending cuts, typically Republicans, argue that only entitlement reform will elevate us to a higher level of fiscal responsibility. Politics will probably mean that both camps will concede some ground on both issues, but here’s the rub: there’s no historical evidence that higher taxes on the wealthy can come even close to paying the government’s current spending bill.
Fifty years ago, the top tax rate in the US was 91 percent, a level that’s hard to imagine in today’s political climate. And yet, even as this tax rate fell to a low of 28 percent in 1988 and then rose to its current 35 percent as of 2012, the amount of revenue raised by the government as a share of Gross Domestic Product (GDP) hasn’t changed that much, an average of 17.5 percent (due to the weak economic recovery revenues were 15.5 percent of GDP in 2012, well below the long-term average).
Part of our fiscal problem is simple arithmetic: the federal government has spent an average of 20.2 percent of GDP over the same time period; the reason we now have $16-trillion dollar deficit vertigo. And, the over-spending problem has worsened recently due to the government’s four year string of trillion dollar annual deficits that grew the size of the federal government to levels that have never been greater, except during World War II. The other part of the fiscal problem arises due to the composition of government spending, and how that has changed.
In 1962, for instance, 70 percent of the federal budget went on public goods such as defense, agriculture, education and energy, 13 percent went on social security, 10 percent went on unemployment compensation and other income security programs, and 6 percent went on interest payments on the national debt.
In 2011, the ledger was very different. Just 33 percent went on public goods, and 6 percent went on interest payments on the debt. But social security and Medicare (which started in 1965) now accounted for 34 percent of the budget, while unemployment and other income security programs accounted for 27 percent.
It should be noted that Social Security and Medicare are projected to cost even more in the future, due to an aging population, continual inflation in health care, and the impact of the Patient Affordable Care Act. Interest payments on the deficit, which are still at 1962 levels, are also vulnerable to any increase in what are currently historically low interest rates.
We cannot simply tax our way out of this math. Even if the tax increases under consideration were implemented, and annually raised the $82 billion expected by the Joint Tax Committee, 94 percent of the over $1 trillion annual deficit would remain. And, due to the negative impact tax increases have on economic growth, the tax increase may raise even less revenues.
This is the fundamental reality of the so-called fiscal cliff. We’ve already fallen off. Climbing out is going to be painful – and it’s going to require us to rethink what we ask of government and not just what we give.
Wayne Winegarden, Ph.D. is a contributor to EconoSTATS at George Mason University, a Senior Fellow with Pacific Research Institute, and a Partner at the economic consulting firm, Arduin, Laffer& Moore Econometrics. Trevor Butterworth is the Editor-at-Large of the Statistical Assessment Service (STATS) and EconoSTATS contributor.