Monday, November 26, 2012

A Fiscal Cliff Compromise

 A brief opinion piece on the Brookings Institute website by William A. Galston gives us an interesting solution to the coming fiscal cliff political brinksmanship.  The Republicans are firmly entrenched in their "no tax increases" philosophy and the Democrats don't want to increase taxes on families making less than $250,000 per year.  Since the two sides of the spectrum obviously cannot agree on long-term changes to the tax code between now and December 31, 2012, a bit of tweaking here and there may just solve the problem at least temporarily.  Without such an agreement, one thing is certain, the world's markets will react adversely.  As it stands now, taxes will go up on January 3, 2013, impacting the "middle class", resulting in slower economic growth according to Congressional Budget Office projections and a loss of confidence in Congressional ability to problem solve. 

Let's look at the summary of tax receipts as a percentage of GDP from 1930 to 2017 from the Office of Management and Budget:

Since the Second World War, total tax receipts have almost never been higher than 20 percent of GDP and have averaged 16.0 percent since 1930.

Here is a summary of total outlays as a percentage of GDP over the same time period:

Since 1976, it is rare that outlays have been less than 20 percent of GDP, ranging from 18.2 percent in 2001 and 2001 to 25.2 percent in 2008.  And thus, the problem.  The author notes that the U.S. government will need revenues of between 20 and 21 percent of GDP to stabilize the national debt (note the word "stabilize" rather than the word "reduce").

Since past history shows that reforming the tax code is a very long and painful process even under the best of circumstances where both sides aren't acting like elementary school children, an interim solution is required that will prevent both sides from pouting.  Here are Dr. Galston's suggestions:

1.) Both sides accept a cap of $50,000 on itemized deductions (i.e. health care, mortgage interest, charitable deductions, state and local taxes, tax preparation fees etcetera).  This would have the greatest impact on individuals making more than $200,000 annually.

2.) Republicans would agree to raise the tax rates on dividends and capital gains, closing the gap between the very low rates of today and those that were in place before the Reagan-era tax reform.  Here is a graph showing what has happened to dividend and capital gains tax rates since 1961:

Common sense would tell us that it looks like there should be plenty of room to move rates up, unfortunately, there is a shortage of that particular commodity in Washington.

3.) In return for these compromises, the President and his fellow Democrats would agree to leave the rates on earned income at current levels.

This scenario gives both sides of the spectrum some form of a victory that they can brag about to their backers, however, in this winner-take-all, loser-gets-nothing world, it is unlikely that even modest compromises like these will be palatable to both sides.  That said, perhaps this solution is just too simple for the complex minds of Congress to absorb.

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