Therefore, if a deal is made and signed into law today that involves setting tax rates at a rate anywhere between today's rates and the Jan. 1 rates, it is a tax hike, and violates the pledge.

However, if the exact same deal is made on January 2, 2013, then it is a tax cut, and does not violate the pledge.

No Republican wants the stigma of having violated the pledge. Yet they realize that the Democrats and Obama simply will not agree to a deal without some tax increase, and the Republicans will take a large share of the blame if they do not find a compromise that raises some tax revenue. They can dodge both bullets if they wait after Jan. 1 to sign any deal into law.

Obama, I believe, realizes this, and prefers to have a negotiating partner that can more easily agree to a tax increase above today's rates. So he too may be more than willing to let the New Year pass without signing a fix into law.

Mind you the deal may happen before the New Year. But I doubt anything will become law until January 2 or later.

But what should the deal be? Stay tuned for the next 21st Centrist post, where we lay it all out...

Sunday, December 2, 2012

So I pay attention when I hear folks talk about balance. It comes up a great deal with the fiscal cliff.

Some deficit hawks insist we need to balance the budget. President Obama and the Democrats disagree, and instead insist on a "balanced approach" to deficit reduction, meaning, per their latest proposals, $1.6 trillion in tax hikes, plus $400 billion in yet-to-be-agreed spending cuts. (Apparently, there is a new definition for "balanced:" utterly lopsided.)

It seems both sides use the word "balance" to give an appearance of prudence and fairness. But they are not saying the same thing. In fact, they are at opposite extremes.

Balance is not such a simple thing. It requires a real grasp of complex forces pushing against each other. A sailor, for instance, has to intuitively balance wind, water, helm and sails – each against the others, each with unique force characteristics – in order to keep a true course and even keel.

Taxes, spending, debt and investment flows are all like the various forces and physical systems a sailor faces at sea, each with different strengths, effects and characteristics. The effect on the economy of $1 of tax does NOT equal the effect of $1 of spending. Government debt has an effect on private investment, but not 1:1. So balance in fiscal governance and economics consists in understanding the differences in these flows, how they act on each other, and applying that knowledge with finesse, trimming taxes and spending, as a sailor trims sails and heading, to keep the national finances and economy on a even keel.

Economists are only just beginning to understand the interplay of these forces. New research is reversing text-book economics on some key points, and refining our understanding of the impact of debt, taxes, and spending.

Three key pieces of new research in particular have a lot to say about how these forces play out, and how we should best handle the debt/fiscal cliff problem. Here they are in brief, with links and a headline each:

1) Set a Safe Debt Target: Keep Debt Well Below 90% of GDP At All Costs.

Rogoff and Reinhart's research presents a compelling, evidence-based middle ground between those who argue for balanced budgets, and those who say debt does not matter, so spend freely. But as the above chart shows, even "safe" levels of debt can expand rapidly, given the right mix of wars, recessions and financial crises... and that is nothing compared to what could happen if interest rates begin to rise above 15% as they did in the 1970's.

In the short term, we need to get back under the 90% mark as soon as possible, say within three years. But that is achievable, and reasonable. In order to fix our debt problem permanently, Congress needs to pick a target 10 years out for Federal debt as a percent of GDP, probably ≤ 50%, so that in the event of a national emergency, there is room to take on debt without going into the danger zone. The US need to adopt a 10 year debt/deficit reduction plan to reach that goal, and thereafter stay in that zone where debt ≤ 50% of GDP (or a rolling average thereof) absent a national emergency.

(2) Do What Hurts Less: Cut Spending, Because Tax Hikes Hurt 3x More

So if a balanced budget is not necessarily the only path to stable prosperity, what about Obama's "balanced approach" to deficit reduction? The argument sounds reasonable: since the spending cuts we need hurt the poor and middle class most, we must tax the rich more, to be fair, so they share some of the pain.

The problem with this argument is the assumption that taxes on the rich only effect the rich. Is that true? And if there is an effect on everybody else, is it really a toss-up between tax hikes and spending cuts as to which is more painful?

"The economists looked at 173 "fiscal consolidations" in rich countries, times when governments decided to reduce the long-run deficit. They then checked to see whether consolidations based mostly on tax hikes turned out better or worse than ones based on spending cuts (Inside baseball: They followed a version of the Romer and Romer event study methodology, but applied it to exogenous-looking fiscal tightening instead of exogenous-looking monetary tightening)

"Here's my favorite graph...[] It shows what happens to consumer spending and real output after the two different kinds of fiscal tightenings. Time in years on the x-axis, percentage changes in spending on the y-axis:

"Both GDP and consumer spending tell the same story: Spending cuts are the less painful path to fiscal rectitude. When countries tried to get right with the bond markets, this IMF study found that nations that mostly raised taxes suffered about twice as much as nations that mostly cut spending.

"We might want to meditate on Figure 9 out here in the reality-based community, since both the U.S. and Europe will be spending some time this fall wrestling with how to get our fiscal houses in order. A benevolent social planner would like to take the least-cost path to solvency, a path probably based on spending cuts and loose money.

"Keynesian Coda: Notice that the graphs are saying that the tax multiplier isbigger than the spending multiplier, at least in these settings. Quite the opposite of undergraduate Keynesianism. This isn't the final word on the matter, but if you'd like to see another study of multipliers that doesn't fit neatly into the Keynesian box--and written by top New Keynesians--check out the abstract and conclusion of this paper by Blanchard and Perotti."

3) Do What Works: Cut Spending... It Works, While Tax Hikes Historically Fail.

If tax hikes significantly hurt the economy, it is possible that GDP and tax revenues will actually fall despite – or because of – a tax hike. In which case, an attempt to reduce debt via tax hikes would fail, while the nation suffers more and more.

"Over the years, many economists have looked at what other countries facing our current debt problems have done. A review of the academic literature on this issue shows that successful debt reduction measures are mostly made of spending cuts rather than a mix of spending cuts and tax increases. For instance, in a new paper, “The Design of Fiscal Adjustments,” Harvard economists Alberto Alesina and Silvia Ardagna provide yet new more evidence that fiscal consolidation based mostly on the spending side are more likely to lead to a permanent and long-lasting reduction in debt-to-GDP.

"As Kevin Hassett and Andrew Biggs of the American Enterprise Institute have shown, a staggering eight of every 10 attempts by countries to reduce their debt-to-GDP ratios are failures. This means that even in a time of crisis (or especially in a time of crisis), lawmakers prefer politics over solid, pro-growth policy. The United States seems poised to do the same.

"What is the impact of spending cuts or tax increases on the economy? First, agreement among economists on the impact of budget cuts on growth is far from being settled. However, a few lessons have emerged. Fiscal adjustments achieved through spending cuts rather than tax increases are less recessionary than those achieved through tax increases. Alesina and Ardagna's research also reveals that private investment tends to react more positively to spending-based adjustments. Thus, they argue that spending cuts are more sustainable and effective in reducing debt and raising economic growth; thus expansionary fiscal policy becomes possible again.

"The bottom line is that Obama's "balanced approach" more closely resembles the historic failures -- the fiscal adjustments that don't successfully reduce a nation's debt-to-GDP ratio. What's more, history reveals that the balanced approach generally results in tax increases but rarely delivers on the spending cuts. That's unfortunate, considering that if the government could actually collect $1.6 trillion over 10 years from tax increases, this amount still wouldn't be enough to fill in the projected $6 trillion cumulative deficit over the period."

So Obama's approach is not only entirely unbalanced, it is exactly the wrong thing: hiking taxes a lot and cutting spending a little sets us up for failure and disaster. We need to do the exact opposite, at least in broad outline, if we want to reduce suffering, raise the general prosperity and erase the debt successfully.

But that is just a broad outline. None of this, by the way, is to say we can't raise some taxes and some revenue, but it is a question only of how to do it in a manner that most promotes prosperity and not contraction. So too, how one cuts spending will make all the difference between cheating millions of vulnerable poor out of promised benefits, and reforming the structure of those benefits so they become sustainable, reliable and an incentive to responsibility and prosperity. True balance in cutting the debt -- balance between maximizing prosperity and expanding our humanity -- is going to be in the details.