The Fiscal Cliff

Disaster Capitalism at its Finest

by Hendrik Van den Berg
UNL Professor of Economics

The news media constantly warn us about the fiscal cliff that our economy is poised to drive over January 1. We are told that the sudden tax increases and sharp cuts in government expenditures scheduled to take effect after the first of the year will push the economy back into recession and raise unemployment back over ten percent. Something must be done!

On the other hand, we’ve just come off an election campaign during which we were continually told by politicians from both parties that unless we cut the government deficit, our children will be doomed.

So which is it then? Must we raise taxes and cut expenditures to save our children’s future? Or, must we preserve government spending and defer raising taxes in order to keep from driving off a fiscal cliff New Year’s Day?

A bit of skepticism is in order here. What we are facing is yet another episode of misleading political posturing by the two corporate-controlled political parties that serve only to cover up the continued manipulation of the economic rules in favor of the already wealthy.

What Exactly Is This Fiscal Cliff?

On January 1, the 2010 temporary two-percentage point cut in payroll taxes will end. This means the average family will pay about $1,000 more in taxes in 2013. Also, the Bush tax cuts will end. Among other things, the 2001 reductions in marginal tax rates from 15%, 28%, 31%, 36%, and 39.5% down to 10%, 15%, 25%, 33%, and 35% will be reversed, the capital gains tax will go back to 20 percent from the current 15 percent, the child tax credit will go back down to $500 from $1,000, many dividends will again be taxed at the marginal income tax rate rather than the lower 15 percent rate, the estate tax will rise from 35 percent back to 55 percent and will again be applied to inheritances over $1 million rather than $5 million, and the inflation adjustment to the alternative minimum tax will end.

These substantial tax increases will be accompanied on January 1 by a reduction in how long unemployment benefits can be paid out, a $120 billion cut in government discretionary expenditures (including $55 billion in military expenditures), and a reduction in Medicare payments to physicians.

There is broad agreement that these tax hikes and expenditure cuts will drive the economy into recession. Even the deficit hawks, who claim that deficits cause all our economic problems, argue that such a sudden shift in taxes and expenditures is likely to be recessionary. But, there is little agreement on how to proceed.

President Obama says he will not accept any deal to address the crisis without a rise in taxes on the rich (people with more than $250,000 annual income), while the Republican leadership has ruled out any increases in taxes. However, both parties seem willing to cancel the programmed cut in military expenditures. In general, the potential courses of action seem to come down to whether one sees unemployment as the greatest problem (in which case an extension of tax cuts and expenditure levels would be preferable), or whether one fears government budget deficits (in which case doing nothing and letting the economy go into a new recession seems preferable). There are better solutions available, however.

A Better Solution

Not all taxes and government expenditures have the same effect on the economy and the government budget. Some taxes would increase unemployment very little, and some expenditures would lead to more new jobs than others. Hence, by merely shifting taxes and expenditures it becomes possible to both reduce future deficits while also avoiding a new recession. These specific decisions run smack up against ideological objections and special interest agendas, however.

For example, the calls by many Republicans and Democrats to avoid cutting the military budget makes absolutely no economic sense. The economic multiplier effect for defense spending is very low—only about a third of the multiplier effects of unemployment insurance, food stamp payments or hiring teachers, according to the Economic Policy Institute. That is, merely taking money out of the Pentagon and spending it elsewhere provides a net boost to the economy without adding to the deficit. Or, if the deficit is such a concern, then cutting defense in half could be neutralized by adding just a fraction of those savings to funding infrastructure projects, unemployment insurance, direct government hiring, etc., thus cutting the budget deficit without adding to unemployment.

Most tax cuts have much lower multiplier effects than direct government expenditures. The rise in the inheritance tax is estimated to have almost no negative effect on employment at all. This latter tax cut in 2001—and its extension in 2009—was nothing other than a gift to the wealthy. There is absolutely no trickle-down effect. In general, tax cuts for the wealthy have much lower economic multipliers than direct benefit payments to the unemployed or the poor.

At the same time, it should be pointed out that adding a bit more to government debt when the economy is in a recession and suffering from high unemployment is not really a problem. With unemployed labor and excess capacity, inflation is not a concern. The very low interest rate at which the government can borrow today (nearly zero percent) makes it clear that the markets have absolutely no fear of inflation. Therefore, the Federal Reserve can create the money needed to fund the budget deficit. Of course, years from now, the accumulated debt could become problematic, but if economic recovery can be maintained, it will actually become easier to reduce debt in the future

In sum, we can reduce the projected long-run budget deficits by both taxing higher-income groups more and stimulating employment by spending more on payments and programs that benefit the lower-income groups. This would also make the budget both more egalitarian and more likely to keep the economy expanding. Who could object to that?

The Hidden Agenda

The real agenda behind the fear-mongering over the fiscal cliff is to get Americans to accept cuts to the social safety net. Note how discussions on the fiscal cliff seldom go in the direction of the solutions just described, but they very quickly end up talking about the need to ‘reform’ entitlements, privatize Social Security and Medicare, cut Medicaid, reduce student aid, etc.

Apparently, there are strong forces at work to privatize anything and everything that is still being done by government. The financial industry has its sights set on Social Security. This very efficient system of guaranteeing that people do not fall into poverty at old age of course competes with private financial groups who would like to run a for-profit retirement system. Of course, a private system will face exactly the same demographic trends that Social Security faces—namely that there will be fewer workers per retiree. A fully private system can thus only provide better returns to some people at the expense of others. Only the financial industry will come out ahead from privatizing Social Security. But, of course, that is precisely why they lobby for privatization.

We also see the Pentagon lobby pushing hard against the scheduled cuts in military expenditures. They seem to be reviving the Cold War in order to get their way. No doubt, Congress and White House will oblige, although neither the budget deficit nor the economy in any way justify maintaining the current obscene level of defense expenditures.

And, of course, the resistance to tax increases on the wealthy is pure special interest politics. There is no economic justification to not tax inheritances, our increasingly concentrated wealth, and high incomes. There is no ‘trickle-down effect’ from lowering taxes on the wealthy, especially inheritance taxes. Remember, our economy generated much higher growth rates and many more jobs when marginal tax rates were double or more what they are now.

Nobel Prize-winning economist Paul Krugman has suggested that President Obama should drive full speed ahead towards to fiscal cliff. Without such audacity, we will almost certainly lose our social safety net. Indeed, if we cannot deal with the fiscal cliff by reshaping tax and expenditure policies (while simultaneously preserving our successful Social Security and Medicare programs), then another recession may be the less destructive policy.

The Deficit Is Not an Urgent Problem

Fact: The government deficit is not equal to 100 percent of GDP. A substantial portion of federal government debt is owed to other government agencies, such as the Federal Reserve. The debt towards the general public is about 70 percent of GDP—still much less than the debt at the end of World War II, and comparable to many other high-income countries.

Secondly, this government debt is not a net burden on our children. Remember, for every debtor there is a creditor. Except for that portion of the government debt that is owed to foreigners, the debt repaid by our children is also received by our children. Of course, it is also true that, in the future, those who receive debt repayments are more likely to be wealthy, and those taxpayers who have to pay the taxes with which the government covers future debt repayments may be middle- and lower-class individuals. But that fact merely provides another reason for taxing the rich more in the future. Future debt obligations are not a reason for cutting government debt today—particularly when for the majority of America’s citizens the ‘Great Recession’ has never ended


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