Watch for President Obama and Congress to reach a pact on the “fiscal cliff” — a consequence of expiring Bush-era tax cuts — amounting to roughly half the spending cuts and tax increases mandated for January 1, says Mark Duggan, Wharton professor of business economics and public policy. Whether or not an agreement comes before the deadline remains an open question. Duggan discusses this and other challenges confronting the Obama administration, including unemployment, in this Knowledge at Wharton interview. Duggan is also director of Wharton’s new Public Policy Initiative, aimed at providing public officials with research-driven ideas to help them plan better.
An edited version of the conversation appears below:
Knowledge at Wharton: Let’s talk about the public policy implications of Obama’s victory in the presidential election. The country’s debt and budget considerations are now the number one issue. All the talk is about the fiscal cliff. Could you explain what that cliff is all about and what the options are for dealing with it?
Mark Duggan: Yes. There are several things on January 1st, 2013, that will happen, both in terms of taxes increasing and spending being reduced in a number of different ways. Currently, the U.S. economy’s GDP for 2012 is roughly $15.5 trillion. On a calendar year basis, this fiscal cliff amounts to about $750+ billion. That’s about 5.1% of GDP in terms of increased taxes and lower spending on an annual basis when we move into 2013. So that is a huge change. It will be a huge jolt to the economy because people are immediately going to see more taxes being taken out of their paychecks and we’re going to see less spending on things like defense, Medicare and various discretionary programs.
This fiscal cliff is baked into the current system unless we make changes. If policymakers do nothing for the next two months, then starting on January 1 we will go over the so-called fiscal cliff and see tax increases and spending reductions that add up to more than $750 billion over the course of the 2013 calendar year. That is a huge change for taxes and spending policies, which threatens the somewhat fragile economic recovery. Policymakers are scrambling to figure out what to do and it’s going to be an interesting negotiation between the two sides.
Keep in mind, the number that you hear a lot in the press is $607 billion, which is the fiscal year number from the congressional budget office. If you look at it on a calendar year basis, it’s in the $750+ billion dollar range. So it’s bigger than it has been being billed in the press.
Knowledge at Wharton: Interestingly it’s the same cast of political characters that have been around before that will be making these big decisions between now and January 1. What do you think is likely to happen?
Duggan: There are certain parts that make up the entire fiscal cliff. If you aggregate the different things: the increases in income tax rates, the increases in dividend taxes and capital gains taxes, the increase in payroll taxes, reductions in defense spending and so forth, there are a couple of components that seem very unlikely to be renewed, which is to say that parts of the fiscal cliff will happen.
Let’s start with the reduction in the payroll tax. Over the course of the 2012 calendar year, payroll tax rates have been two percentage points lower than normal. So if you’re working and earning $50,000 a year, you’ve paid $1,000 less in Social Security payroll taxes in 2012 than you would have otherwise. If your salary stays the same in 2013, your take-home pay will fall mechanically by $1,000. All signs indicate that the government is going to let this tax break expire. It’s very expensive; it’s worth over $100 billion and we think this is very unlikely to be extended.
The second component is emergency unemployment insurance benefits. In a typical economy, unemployment insurance provides benefits for up to 26 weeks, and if a person doesn’t find a job within 26 weeks, their unemployment insurance benefits are exhausted. During this recent economic downturn the federal government intervened in many ways to extend that maximum duration to as high as 99 weeks. That’s gradually been coming back down and it’s going to come back further still. This is also a very expensive program and all signs indicate this will not be extended.
Those are two examples of parts of the fiscal cliff that are likely going to take effect.
Other parts of the fiscal cliff are somewhat harder to predict in terms of extension or expiry. For example, income tax rates are generally set to increase across the board. The 10% marginal tax rate, which affects lower-income people, is set to increase to 15 percentage points. That is a pretty big increase. This will mainly affect lower- and middle-income workers, but it also affects all other taxpayers because everyone pays that percentage of tax on roughly the first $9,000 they earn in taxable income.
For those higher earners who are making, for example, $400,000 per year, tax rates are set to increase from 35% to 39.6%. Tax rates had originally been at this higher level but George W. Bush lowered the tax rate for high earners from 39.6% to 35% in 2001.
The question of whether to extend tax cuts for lower- and middle-income workers but let them expire for high-income workers, or vice-versa, will be a defining issue.
I think both the Democrats and Republicans would be very happy to keep those tax rates lower for the low-income folks. But a big point of debate will be surrounding the high earners: should we allow those rates to go back up to start to make a dent in the deficit?
Estate state tax will also be a huge issue. Currently if you pass away and your estate is worth less than $5 million, no taxes will be paid on your estate. But in 2013 the threshold falls from $5 million to $1 million, and on top of that the tax rate will increase. Dividends and capital gains taxes are also set to increase.
This is going to be a very interesting negotiation because policymakers will have to find the mix between tax cuts, tax increases and spending cuts. If policymakers do nothing, the changes that are set to go into affect have more than $3 in tax increases for every dollar in spending reductions. While the spending reductions are not trivial, the vast majority of the $750 billion fiscal cliff is going to come through higher taxes. Predicting the final outcome is difficult: but it’s plausible that roughly half of the $750 billion will be averted.
Knowledge at Wharton: In Europe, cuts in government spending appear to have made the public debt worse. Austerity has resulted in slowing down the economy and, at the same time, it increases spending for safety net issues. The current policies seem to be having exactly the opposite effect of what was intended. Do you agree that that is the case? And how would the U.S. avoid getting caught in such a trap?
Duggan: It’s an extremely delicate trade-off that policymakers now have to face. I wish that I could have great confidence that they’re optimally making this trade-off given the best available evidence, but that’s not always how policy-making works unfortunately.
There have been indications over the last few months that the economy and job growth are improving. It would be highly unfortunate if this fiscal cliff dragged us back into a recession, which is totally plausible. Policymakers will have to find a balance.
Right now, for every $3 the federal government spends, it borrows $1, and that is a big deficit. Most people agree that in the long run we want to get that deficit down, but when do we start trying to make a dent in that? That’s the critical question. How do you start to make progress on reducing the deficit in such a way that you don’t hurt the economy?
Policymakers have to ask the critical question: ‘where between zero and $750 billion is the right number?’ I believe $750 billion would pose major problems for the economy, but I do think there’s value in starting to make a dent in the deficit. There’s going to be tradeoffs because whenever you raise taxes or lower spending, people are affected.
At some level, what we’re talking about right now is changing the parameters within the existing tax code. Many economists and experts hope that policymakers will soon get together to design a tax system that makes more sense. We need a system that is more pro-growth; a system that reforms entitlement programs and gets the country on a better, long-run fiscal trajectory. My hope is that instead of tweaking within the existing tax code and tweaking within existing entitlement programs, policymakers try to put the country on a better overall economic trajectory.
Knowledge at Wharton: You’re suggesting that a compromise on the fiscal cliff may come down somewhere in the middle. How much of a dent does that make in the deficit or in the budget for the year?
Duggan: In terms of our deficit for this past 2012 fiscal year, it was essentially $1.1 trillion, which is $11,000 billion. I’m not going to use the 2013 number because the numbers are fiscal year, so 2014 would be the first full fiscal year that we will see post-fiscal cliff results — but by 2014 you could see the deficit decline by about two-thirds if we went over the fiscal cliff. So this would make a giant dent in the deficit. Even if it kicked the economy into a recession, it would still lower the deficit, but it wouldn’t lower it as much if it hampered economic growth.
Where’s our current debt? Debt held by the public is about $11 trillion. If you take gross debt, which includes what the government owes, that’s $16 trillion. What we’re talking about is $750 billion, which is smaller scale but still rather significant. That’s 5% of the overall gross debt. So a move in that deficit on a per year basis is a pretty big deal.
Knowledge at Wharton: The other big issue in the presidential campaign was unemployment. The numbers have been improving, with the economy creating 170,000 jobs in October. That’s just a little bit better than keeping up with population growth. If we increase employment by that amount every month for the next many months, it would take many, many years to get unemployment rates down to the level that they were at before the financial crisis. What do you see happening with unemployment?
Duggan: Most people who specialize in studying this area hope that policymakers are going to use pro-growth strategies to boost economic growth and enhance job creation. However, within our tax code there are a lot of well-intentioned policies, but in aggregate the system is a complete mess. Policymakers will have to rationalize this area to stimulate investment by companies and encourage job creation. I think this would have desirable effects on employment growth.
Meanwhile, 170,000 jobs a month is good, and it’s a little better than keeping up with population growth. But basically, in terms of employment, we are about four to five percentage points below where we were before the financial crisis started, which impacts millions of people. At this rate, it is going to take a long time for us to get to where we want to be. That is why policymakers will have to enact effective policies at all levels to deal with this problem, for example in trade, energy, health care, housing, financial regulation and so forth. Then as the economy grows, the deficit becomes less and less of a problem because mechanically you’ve got more people generating tax revenue and, fewer people going onto government programs. In this way, the problem can, to some extent, take care of itself. But 170,000 new jobs a month is just not enough. The answer is to grow your way out of the problem.
Knowledge at Wharton: But how do we actually manage to grow our way out of this problem?
Duggan: It will be difficult for policymakers to design a package of policies that simultaneously reduce the deficit, which involves a combination of increasing taxes and lowering spending, while also enhancing job creation. This will require a better policy-making process than we’ve seen in recent years. Unfortunately, the current environment has not been conducive to fostering economic policies that are in the country’s long-run interests. The vast majority of policymakers in DC are well meaning and very smart, but the process as a whole is just a disaster for the country. So I hope they can work together and make compromises. The country needs to come together to tackle these massive challenges to put the U.S. on a better fiscal trajectory.
I believe effective trade policy has the potential to foster job creation because it will help open up markets abroad and increase their demand for our products, which will raise exports and thus raise employment. Unfortunately, the rest of the world is also struggling, which makes this more challenging.
There are also many opportunities to stimulate job creation through energy policy. The energy sector could become a solid source of employment growth. Effective policies would help the U.S. reduce its dependence on foreign petroleum and energy. For example, the U.S. has a very large amount of natural gas reserves and there are questions about whether we should be doing more to harness this energy. Currently, natural gas is roughly a quarter of our energy consumption, but it could potentially increase with effective government policies. There is also the fossil fuel versus renewable energy issue. While renewable energy is a very small part of our overall energy consumption, policymakers could look at this area to see if there is an efficient way to stimulate more production and demand. Furthermore, nuclear power could be a possible source of increased energy.
Keep in mind though that everything is connected when it comes to government policies for spending, taxes, energy, trade, housing, etc. When you move one policy you often have ripple effects in other areas, which could be beneficial or could be detrimental. For example, if you decide you want to tackle climate change, you could increase the gasoline tax, which would potentially help you with both the budget and climate change because it would encourage people to buy more fuel-efficient cars. That’s an example of one case where you could kill two birds with one stone. Unfortunately, most policy changes that create a benefit on one front can cause harm elsewhere.
Experts who specialize in government policy can help policymakers think through their proposed policies before they are enacted to ensure unintended consequences are kept to a minimum. I really hope that these policymakers will call on the expertise outside of their offices because they are dealing with very complicated issues and, as smart as they are, they often don’t understand the trade-offs.