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Fiscal Cliff? More Like a Fiscal Mountain

12/12/2012 --

Professor Joel Slemrod says the U.S. has a long climb ahead to get spending and taxes right.

ANN ARBOR, Mich. — It might not be a happy new year if a deal on the so-called fiscal cliff isn't reached. If the president and Congress can't agree to extend the deadline or come to terms on a tax and spending bill, several tax cuts will expire and mandatory spending cuts will go into effect. Nearly everyone would face a tax increase, and spending on key federal programs would abruptly be cut — both of which could hamper a fragile recovery.

While there are a lot of numbers being thrown out by both political parties, Ross professor Joel Slemrod said what's more important is how we get to those numbers. But political leaders haven't been very forthcoming on that subject.

Slemrod, the Paul W. McCracken Collegiate Professor of Business Economics and Public Policy, says there's probably not enough time to reach a grand solution on the long-term fiscal imbalance. Instead, one or more stop-gap agreements are more likely. While he agrees that now might not be the best time to raise taxes and cut entitlements, it's a pill the country has to swallow eventually. That's why Slemrod thinks "climbing a mountain" is a better metaphor for the situation.

Along with Leonard E. Burman, Slemrod co-authored the new book Taxes in America: What Everyone Needs to Know (Oxford University Press).

Where do you think we will end up come Jan. 1?

I think the most likely outcome, as of now, is that there will be an agreement to put off the expiration of all or most of these tax cuts. The political deadlock might go into January, and that will mean middle-class people paying a lot more tax for a couple of weeks. But I don't think either party wants that. It'll take a long time to come to an agreement to overhaul taxes and spending, and a few weeks during a lame-duck session probably isn't the best time to do that. Matthew Miller of the Washington Post suggested we might see a series of cliffs. That would be a bit worrisome because of the uncertainty. Businesses and individuals have a hard time planning with that kind of uncertainty, and I think that's bad for the economy.

There are some dire predictions of what would happen if the tax increases and spending cuts went into effect. But you've done some research that suggests that might be overblown?

I have done some research with colleague Matthew Shapiro that showed when people received their tax rebates in 2008 and tax cuts in 2009, they didn't spend the extra disposable income as much as predicted. That evidence suggests that if taxes go up, people might not cut back spending as much as some predict. The key question is if what we found works in reverse. But I'm in the camp of people who thinks that if these taxes do go up in January, it won't be as big a hit to the economy as some think.

But you still think going off the cliff — letting the tax cuts expire and enacting mandatory spending cuts — would be a bad thing come January? You have said a mix of cuts and tax increases would be the best way to deal with the fiscal imbalance.

I think of it more as approaching a mountain, and there are good ways and bad ways to go up that mountain. I think we're going to have to climb the mountain eventually. Most economists agree that in the long term, we need a combination of tax increases and spending cuts because the long-term budget is so out of whack. But right now, we're in a very delicate recovery and there is legitimate concern that substantially raising taxes and cutting spending could cancel the recovery or slow it down. But there's this dilemma that it's almost never the right time to think about raising taxes and cutting spending. I think that is the fiscal dilemma: If this isn't the right time to do it, when will it be?

Why should Congress take its time on this?

Because it's not just a matter of numbers, or of how many hundreds of billions should be cut in spending and how many hundreds of billions we should increase taxes. It's exactly what spending should be cut and how we would raise the revenue. If we're going to reform Social Security and Medicare, how are we going to do that? If we're going to increase taxes, how are we going to do it? Are we going to raise tax rates? Are we going to cut deductions? In the mid-'80s, we basically spent two years debating tax reform. And we really haven't had much of a serious discussion since then. Cutting Medicare and Social Security is going to be even more divisive than how to raise taxes. I don't think we've really had a serious discussion about how to do this. Both sides have plans with some numbers, but nobody really has said how it's going to happen. So as much as I don't want to keep putting this off, I don't think Washington can put together a thoughtfully constructed, long-term solution to this issue in a couple of weeks — or even months.

Why would this be more difficult than the Tax Reform Act of 1986?

Our last comprehensive income tax reform occurred in 1986. But it is not a perfect model for the legislative challenges that lie ahead. For one thing, the 1986 tax reform was designed to be revenue-neutral. Now we're talking about ways to raise revenue, and there are multiple ways to do that. You can just increase the tax rates and keep the tax code the same, or you can cut back on deductions and preferential taxation. But which ones? Do you cut the tax exemption on healthcare benefits? The deduction for charitable contributions or local taxes? How about the mortgage interest deduction or the preferential treatment for capital gains and dividends? The same devil-is-in-the-details issue arises for entitlement reform. Do we raise the eligibility age for Medicare to keep it solvent, or do we means-test it? Just listing these options makes it clear this is not going to be politically easy. There's no painless way to do it.

But if you say this imbalance is a long-term issue, is there a way to do these over time to make it less painful?

That depends on the credibility of Congress and the president. One can imagine an agreement to raise the eligibility age for Social Security and Medicare to 67. For example, you could increase it one month a year over the next 24 years. That gets you to 67 in 24 years without greatly affecting anybody who is going to retire soon. But I don't think either party has established enough credibility on this issue yet.

How much of a complication is it when the president only talks about increasing taxes for the top earners, but on the flip side many Congressional Republicans signed a pledge to never increase taxes?

It's a political hurdle to have something formalized that says you will never raise taxes in any way, not just tax rates. And President Obama hasn't talked much about a bill that touches entitlements. It's not enshrined in a pledge, but he's been quiet on the matter.

You can find more information about Slemrod's book here and read Forbes' review here.

— Terry Kosdrosky



For more information, contact:
Terry Kosdrosky, (734) 936-2502, terrykos@umich.edu