The Real Economics of the Fiscal Cliff

            Thank goodness for the fiscal cliff.  Without it, most of Washington would be home for the holidays, happy to put off the unpleasantness of raising taxes and cutting spending.  But the truth is, the only part of the cliff that really matters right now is the Bush tax cuts.  Yes, much has been made about triggering large, across-the-board cuts in defense and domestic spending.  But nobody in Washington wants them to happen – not the administration, and not either house of Congress.  And whenever there’s a bipartisan consensus not to do something, it doesn’t happen.

            Of course, there is no such consensus about most parts of the Bush tax cuts.  There is, however, tacit bipartisan agreement that all of them shouldn’t simply expire.  So even at this late hour, we can be pretty certain that they won’t.  Unhappily for Speaker John Boehner and his party, the part with virtually universal support is also the only part the President wants to extend unchanged -- the lower tax rates for the 98 percent of Americans earning less than $250,000.  That leaves the rest of George W. Bush’s vanishing economic legacy up for grabs.  And that includes not only the current 35 percent and 33 percent top rates that everyone talks about, but also, and frankly more important, the special 15 percent tax rates on capital gains and dividends.

            So, thank goodness for fiscal cliff, because it produced a sense of urgency that now seems likely to lead Congress, ultimately, to rebuild part of the government’s tax base.  The big question to settle before New Years is whether that will include a top rate that goes all the way back to 39.6 percent or only part of the way back to, say, 37.5 percent, plus some additional revenues from limiting the deductions claimed by the same well-to-do people.

            As a matter of social policy, the top rate is much less important than what happens to capital gains and dividends.  Successful lawyers, doctors, consultants and small business people care how high the top rates go.  But those rates are matters of indifference to rich people, because most of their seven- and eight-figure incomes come through capital gains and dividends.   Since George W. Bush, they’ve gotten away with rates lower than the middle-class.   And if their 15 percent rates expire and they jump up to normal income tax rates, early next year the President can trade off, say, a 25 percent rate on capital income for Republican agreement to smaller cuts in entitlements.

            But what about the economics of all of this?  There is some debate among economists about whether higher tax rates on capital income matter much.  But the only genuine economic imperative today is that the two parties cut a budget deal.  Over time, yes, we need to take serious steps to both slow the growth of entitlements and further rebuild the tax base.  That’s what Congress and the President did in the 1980s and again in the 1990s; and both times, it took several years of haggling and incremental measures.  For now, global investors believe the United States will do that again, which is why 10-year Treasury bonds yield less than 2 percent.  What the economy needs most over the next several months, then, is a deal that’s significant enough to confirm their confidence, even if it doesn’t solve the whole problem. 

            As to the content of that deal, that matters much less economically, especially for the short-term.  In terms of overall investment, consumption, growth and employment in 2013 and 2014, it really won’t matter much whose taxes go up.  Nor will the overall economy care whether the spending cuts come from Medicare, Medicaid, national parks or national defense.  Of course, different sectors and businesses will care, as will those whose taxes increase.  But what will count for global investors and the economy is that something substantial gets done.   If the deal includes serious steps to slow future entitlement spending, all the better.   But economically, it just has to get done sometime over the next several years.

            Other things, however, could shake our economy.  The European sovereign debt crisis remains a serious threat, but not because a collapse of Greek, Spanish or Italian debt would infect confidence in U.S. Treasuries.  The real issue is that such a crisis would threaten the solvency of many major French and German banks.  That would affect us, because our banks are closely linked with them through thousands of deals and other transactions, and through credit default swaps guaranteeing the corporate paper of the big European banks as well as Italian and Spanish sovereign bonds.

            Here’s a practical step for the Administration:  The Treasury and Fed should conduct new stress tests of large U.S. financial institutions to establish how well each of them would weather a broad European banking crisis.  Such a public accounting would help insulate us from the shock of a Eurozone meltdown and ensure that our financial system will withstand it.

            Another thing holding back a stronger expansion next year is everyone’s experience from 2010 and 2011, when the economy gathered strength and then petered out.  There were good reasons in both of those cases – especially in falling housing prices and a continuing drive by American households to pay down their debts.  Those reasons, happily, no longer apply.  Still, a lot of hesitation remains out there, by businesses about investing and hiring and by households about how much they can spend without getting nervous.  So, the economy could use a little push.  That’s what the Fed is trying to do through QE3.  That’s what the President wants to do with a little more stimulus next year.  And this should remind Congress that that it needs to slowly phase-in its tax increases and spending cuts, as the economy gathers strength. 

            Finally, Congress and the President need to show global investors that they take seriously America’s responsibility as the nation whose currency is the medium for world reserves, by passing the ministerial legislation that raises the legal debt ceiling.  Some members will be tempted to use the debt ceiling once again as leverage for spending changes they sincerely believe in.  But there would be no clearer demonstration that America has lost its political capacity for economic leadership than to make that authority hostage to a political argument.

            And in the end, an amicable resolution of the fiscal cliff and debt ceiling issues just may be enough to support a stronger expansion next year than most people expect — and everyone can share the credit.