The Lesson of the Tax Deal and the Deficit: Teach Your Kids Chinese

Many Republicans  are trumpeting the compromise worked out with the Obama administration this week as a victory -- after two years of class warfare, the administration accepted a deal in which all of the 2001 and 2003 Bush tax cuts will be extended for two years.  While the estate tax rate will rise from zero in 2010, GOP leaders are also pleased with the $5-million exemption and 35% rate on amounts above that, which will be in effect for two years.  Many liberals in Congress are steamed and are threatening to vote against the bill; they hate that the top tax rate on high earners will not be raised, they believe the estate tax compromise is too generous, and they do not want to vote to affirm the Bush tax cuts.  The left's anger also makes the deal look like a victory for the right and the GOP.

On the other hand, Charles Krauthammer thinks the GOP was rolled and that the deal will help Barack Obama in his reelection bid for the one job the president truly has always been concerned about preserving.  The deal, according to Krauthammer, makes the president look like the centrist, having had to fend off both the angry left in his own party and the greedy Republicans concerned only with tax cuts for the rich.  Obama condemned both groups in his nasty remarks at the press conference defending the deal the other day, and that nastiness may explain why there has been no bump whatsoever in his approval rating so far.

That nastiness may not have been faked.  Obama is a true class warrior, and he had to be angered to see his signature tax stance -- higher rates for the rich -- go down the tubes, along with pretty much the rest of his domestic agenda, given the November election results.  Some liberal writers, such as Ezra Klein, have argued that there is enough new stimulus in the compromise bill to have a very positive effect on the economy the next two years -- raising the GDP growth rate by a percentage point or more and lowering unemployment by 1%-2%. This, Klein thinks, augurs well for Obama's reelection effort and for Democratic prospects in general in 2012.

The tax negotiations followed by a week the release of a report by the president's "Deficit Commission."  That group  fell short of the fourteen votes needed to make a formal recommendation of their plan (the vote for the plan was 11-7).

The commission's plan would have reduced the federal deficit by $4 trillion over the next ten years through a combination of tax increases and spending cuts.  A larger share of the proposed deficit reduction would have come from spending reductions than from tax increases, some of which were in the area of defense spending.  Regrettably, the commission did not substantively address federal health care costs, the biggest problem of all.  Of course, the deficit reduction from the commission's suggested approach would merely be a reduction in the level of increase in the total federal debt that would otherwise be run up in this ten-year period.  It was not a reduction of the total federal debt from its current record-high level of about $14 trillion, $9 trillion of which is owed to others ($5 trillion is owed to ourselves -- e.g., the Social Security Trust Fund IOUs).  Among the members of the commission who voted against the  recommendation were liberal Democrat Congresswoman Jan Schakowsky and conservative Republican Congressman Paul Ryan.  Not surprisingly, Schakowsky thought the spending cuts were too harsh and the tax increases insufficient.  Ryan thought the spending cuts were insufficient and the tax increases too high.

The compromise tax bill that was agreed to by GOP leaders and the White House has just added one trillion in new federal debt over the next two years.  It is amazing, the difference a week makes in Washington.

The lesson of the last two weeks is that Republicans publicly proclaim that they care about the deficit, cutting spending (except for defense), and cutting tax rates for everybody, including corporations.  But when a deal is on the table, they will settle for cutting tax rates and agreeing to more spending and higher deficits.  Democrats publicly proclaim that they care about increasing spending (except for defense, and especially in a  weak economy),  raising tax rates on the rich, and reducing the deficit (though not now).  But when a deal is on the table, they will settle for increasing social spending, lowering tax rates, and increasing the deficit. 

The net effect is obvious: the Deficit Commission called for each side of the political debate to accept some pain -- for the right to accept higher taxes, and for the left to accept cuts in spending.  Neither side would agree to that.  The tax extension compromise shows that each side is willing to do what its members believe matters most for their side and causes no pain -- higher spending on social programs for the left, lower tax rates for the  right.  The net effect of this compromise is a substantial increase in annual deficits and a much more rapidly accumulating federal debt.

Of course, federal budget accounting is odd, to say the least.  An extension of existing tax rates is not any new stimulus, but it counts as new deficit, since the current rates were supposed to expire at the end of 2010 and then rise to levels in effect before the 2001 and 2003 cuts.  Since the federal government is now borrowing about forty cents to support every dollar of federal spending, the failure to raise tax rates (or cut spending) does lead to additional deficit spending in the future.  Both Republicans and Democrats were quick to say that what they did this week was necessary because the economy is so weak, and in the end, the deal will help fix that.  Since both Republicans and Democrats routinely vote to increase spending and cut taxes when the economy is strong, the only common denominator is that in good times or bad, the deficit increases.

Republicans have been arguing that they have won the ideological battle over tax rates, since the Obama administration accepted in the end that it is a bad idea to raise tax rates in a weak economy and that lower tax rates are stimulative.  On the other hand, the Democrats won an ideological battle, too, since the Republicans have argued that the prior stimulus bill passed in February 2009 was an expensive failure (it was) but are now accepting that a new stimulus package is needed. 

The compromise reached this week will have about $300 billion in what could be called new stimulus out of the trillion in total cost over two years, all to be financed with new debt.  Extending tax rates and unemployment insurance already in place does not count as new stimulus.

Will that new stimulus money do the trick for the economy in the next year or two, when $862 billion did not do much the last two years?  

If the GOP had been willing to accept the Schumer compromise (a rate increase only for those with incomes over $1 million) and an estate tax rate of 45% on estates over $3.5 million, could the package have passed without all the new spending and the Social Security tax rate cut for one year that Obama demanded in return for the lower rates?  The evidence of the last two years is that much of the stimulus bill spending -- transfers to the states and local governments -- did not create any new jobs, but did allow these governments to reduce their own level of borrowing.  In essence, federal borrowing replaced state and local borrowing.  On the other hand, the temporary tax giveaways -- Bush's $150-billion handout in early 2008, and the stimulus bill's "Making Work Pay" tax cut, were largely used by individuals to reduce their personal debt levels -- part of the national deleveraging going on in all sectors in the economy except for the federal government.  The 2% one-year reduction in the Social Security tax rate will probably have the same result.

It is an article of faith on the right that permanent reductions in tax rates have far more impact on economic behavior than one-time reductions in tax rates or the federal government sending out one-time checks.  But the GOP just agreed to a two-year extension of tax rates, a two year extension of the AMT "fix," a thirteen-month extension of payment of up to 99 weeks of unemployment insurance, and one or two years of extensions to lots of other spending and tax programs tailored to reward special interests.  All of this was demanded by Harry Reid and Senate Democrats to make the overall deal more palatable to Democrats in Congress. 

The Deficit Commission recommended eliminating many, if not most, of all the special rules in the tax code that favor particular industries (e.g., real estate, oil and gas, Hollywood, ethanol, private equity-carried interest), all of which serve to produce higher individual and corporate tax rates.  If the GOP really believes that permanent lower tax rates are the way to help get the economy going again, then this should be their theme song.  The Deficit Commission said that a 23% top rate is possible by eliminating all deductions.  Even keeping some of the most popular deductions and eliminating others would allow for a 29% top rate.  Corporations have a high top tax rate of 35% (almost all of our economic competitor nations have a lower top rate) but pay little in overall corporate taxes due to all the special deals their lobbyists win for them.  Did the GOP sell its "deficit reduction" soul this week in order to keep a top rate of 35% for individual earners with $1 million or greater income for two more years?

Politicians love complexity.  So do lobbyists, who get paid to produce it.  And lobbyists help elect the politicians who write the bills they want or let the lobbyists themselves write them.  During the Reagan years, the president and New Jersey's Democrat Senator Bill Bradley agreed on changes in the tax code and the elimination of some deductions and credits that enabled the top tax rate to fall to 28%.  If Republicans support a similar approach, one recommended by the Deficit Panel -- lower rates with fewer deductions to produce equal or higher revenue (a surefire way to test the power of supply-side economics) -- then they have an opportunity, when they take control of the House in January, to make this their agenda and resist the call for more special favors from the K Street crowd.  If they go the easy route, now that tax rates are set for two years, and dance with the lobbyists, President Obama may preempt them by offering such an approach, as he has already assigned a White House task force to examine this.

At the moment, total federal revenues are 15% of GDP, well below their historic level of 18%.  There is no one in D.C. who believes that federal spending can get down to 15% of GDP.  It is now at about 25%, 5% more than when Obama came into office.  If entitlement spending is not contained, the country will go broke in short order, and the Greek/Irish/Icelandic solution -- sharply lower federal spending and increased taxation producing a lower standard of living -- will be forced on us by creditors.  In other words, the government can produce a plan (as Paul Ryan has) and adopt it, giving the country the means to moderate government spending curve over time, or we can continue to push things down the road two years at a time until we are forced to adjust in a much more abrupt manner.  Deficits matter, and politicians time and again refuse to address the issue. 

Both parties like to say they are serving the middle class.  The Democrats do not want to be perceived as helping merely the poor, and the Republicans do not want to be seen as helping merely the rich.  And both have to a large extent participated both in expanding middle-class entitlements and reducing tax rates for the middle class.  And this is why it will be so hard to break the pattern.  The middle class likes all the benefits and likes the lower tax rates, and the middle class constitutes most of  the voters. 

I agree with the Deficit Commission: federal spending is a far larger problem than insufficient tax revenue.  The Democrats in Congress and the president passed the new health care reform bill in March that will add about $250 billion a year on average for the first ten years after being fully implemented in 2014.  Most of that new spending will subsidize the cost of health insurance for the middle class.  The Democrats are betting that once the benefits begin to be received, it will be politically impossible to take them away.

Our recent political history suggests that we will keep on punting our spending/deficit problems down the road.  If that is the case, we may want to have our children and grandchildren learn Chinese.  For the Chinese will be our economic masters.

Richard Baehr is chief political correspondent of American Thinker.