11/14/2012 05:30 pm ET | Updated Jan 14, 2013

The Better Base Case

The fiscal cliff is the culmination of Congress's propensity to manufacture artificial crises from which it then hopes magically to extricate itself. Watching the process is like a seat at a performance by a clumsy Houdini, who thrills his audience a little too much when he binds himself in chains and then tries to escape while holding his breath underwater.

As the nonpartisan Congressional Budget Office (CBO) has explained, Congress would induce a recession in the first half of 2013 if it allowed all the scheduled tax hikes and spending cuts to arrive simultaneously on Jan. 1 (The International Monetary Fund has recently offered similar advice to Europe.) But the CBO also has reminded us that tax hikes and spending cuts cannot indefinitely be postponed, because government debt would then rise to unacceptable levels.

Trying to rewrite all of our tax and spending policies in one grand bargain in the next few months is just too big a pig for the legislative snake to swallow. The trick is to break the problem into more digestible components, while still linking each step to the other. That's what the Better Base Case legislative package sets out to do.

Here are its components:

  1. Repeal the automatic spending cuts scheduled to begin January 1st, and raise the debt ceiling.
  2. Adopt a tax system projected to yield revenues over the next 10 years equal to the CBO's "baseline" projections, but with a three-year phase-in and with the structural tweaks described below.
  3. Adopt a new Budget process, under which Congress binds itself going forward to keep a "scorecard" of future spending cuts, compared with CBO baseline spending; under this law, future net spending cuts would automatically be applied to reduce tax rates, in the manner explained below.

The result? A budget that in all cases would keep deficits at very low levels, and that would allow Congress over time to agree to spending cuts, impelled in that task by the knowledge that every net spending cut delivered would automatically translate into lower taxes for constituents.

The first point needs little explanation. The debt ceiling simply represents a grant of authority to pay the bills that Congress previously required to be incurred. The debt ceiling is a formality without any consequence, other than near-fatal consequences if it is not raised. Similarly, repealing the automatic spending cuts will inject about $100 billion of economic activity back into the system for 2013 alone. More substantively, across the board spending cuts always are stupid policy. If your internist tells you that you are 10 percent overweight, she will not in the next sentence suggest that you lop off 10 percent of every organ and limb. Spending cuts that are not focused on actual fat have a similar effect.

The second recommendation is a little more complex. The CBO's baseline projections of future government spending and tax revenues show the federal government's deficits coming down to very low levels over the next 10 years (about one percent of GDP). That is, under the CBO's baseline projections, there is no medium-term fiscal crisis at all! The largest driver of those rosy projections, however, is the assumption (which the CBO is required to follow) that all of the Bush tax cuts will expire at the end of this year.

As developed in a paper I co-authored with Joseph Rosenberg of the Tax Policy Center, the Better Base Case embraces those baseline revenue projections, but with a three-year phase-in period, to minimize any short-term economic disruptions. Then it improves the tax system (for example, getting rid of the dreaded AMT), and finally it relies on the new Congressional scorecard to automatically buy down those higher tax rates as new spending savings are enacted.

The expiration of the Bush tax cuts would basically take us back to the tax system in place during the Clinton Administration (with the addition of the new Medicare tax on the investment income of high-income taxpayers). Putting aside theoretical debates, as a practical matter we all know that those rates, while less pleasant than those we have enjoyed the last ten years, did not cause commerce to grind to a halt; to the contrary, those were exceptionally robust years for the economy. Especially with a three-year ramp back up, we ought to be able to make that same level of sacrifice again.

The tax system circa 2000, however, had several conspicuous structural defects. The individual AMT was one, but there were other major flaws as well. The Better Base Case addresses those flaws by proposing the following amendments to the baseline tax law:

  1. Permanently repeal the individual AMT.
  2. Retain the child tax credit at its 2012 level.
  3. Keep the tax rate on dividends the same as the tax rate on capital gains (20 percent), rather than reverting to a system where dividends are taxed at full ordinary income rates.
  4. Reinstate 2009's estate tax rules (a3.5 million exclusion (permanently indexed for inflation from 2009) and 45 percent tax rate). This is much more generous than the estate tax laws assumed in the CBO's baseline revenue projections.

These tax tweaks all cost the government money relative to the official CBO baseline. We pay for these improvements to the tax law by limiting the standard deduction and personal itemized deductions (home mortgage interest, state and local taxes, charitable contributions, etc.) to a 15 percent tax benefit. As our article explained, this addresses the "upside down" nature of the personal itemized deductions, in which the same $100 deduction is worth more to a rich taxpayer than a middle class one, and mitigates the economic inefficiencies that those deductions have introduced. Moreover, the legislation enacting all these changes can be drafted in a matter of hours, not weeks.

Business tax reform also is urgently required, but that reform almost certainly will be roughly revenue neutral in shape; that is, it will neither add to the deficit nor serve as a vehicle for deficit reduction. It thus can proceed on a separate track from resolving the fiscal cliff.
To this point, the Better Base Case sounds as if it solves the short-term fiscal cliff and the medium-term ballooning deficit problem entirely through the tax system. That is not my goal. The third leg of the Better Base Case is the adoption of legislation under which Congress would agree in advance that future net savings in government spending, again relative to the CBO's baseline, would automatically go to tax reduction. This would be a simple system that looks only to aggregate government spending in each of the next 10 years, compared with the CBO's 10-year forecast.

The automatic tax reductions would roll back the new higher tax rates to 2012's levels, starting with the lowest tax bracket first. The reason to apply the savings in order is that all taxpayers, rich and poor alike, get the benefit of the lower tax brackets. A married couple with $1 million of income in 2012 pays tax at the 10 percent rate on their first $17,400 of taxable income, just as does the family with only $17,400 of taxable income in total. By buying down tax rates from the bottom up, the savings are shared equally.

Where would the final balance between spending cuts and tax hikes come out, and which spending programs would be curtailed? I have no idea. Under my proposal, however, every member of Congress will have strong reason to look for spending cuts, because each net reduction will bring new tax relief to constituents. So Congress over time would buy the tax relief that best balances what we want from government and how much we must pay for it.
Can a future Congress evade the ground rules I outline here? Of course it can; congressional laws and internal rules do not bind future Congresses. (The only way one Congress can bind the future is by issuing debt.) But the Better Base Case puts in place a level of tax revenues, and a path to buying down those higher taxes, that should have sufficient logic and power to survive efforts to tear it apart.