Issue #25, Summer 2012

The Looming Showdown

Come next January, our dysfunctional system will have to function. Here’s one possible path toward an outside-the-box budget deal.

What to do during those periods of divided government (which is likely to be most of the time) with few moderates? As I have argued elsewhere, the best we can do to avoid gridlock may be to expand the degree of “automaticity” in the legislative process while retaining full congressional prerogatives to unwind such automaticity. For example, rather than requiring specific affirmative votes in Congress to extend stimulus measures, a better approach is to tie the stimulus measures to an objective indicator, like the share of the population working, and have those measures continue as long as the indicator (in this case, unemployment) is above a specified level. That way, the measures remain in effect as long as they are necessary, without the need for new legislation (though Congress can retain full authority to undo the measures at any time).

Similarly, even a divided Congress is often able to agree upon a process with uncertain outcomes, such as the creation of commissions tasked with finding solutions that take effect unless voted down by Congress. The base realignment and closure (BRAC) process provides a powerful example. It seems implausible that Congress would be able to agree upon which military bases to close through the normal legislative process. But through the BRAC process, first enacted in 1988, Congress delegates the job of choosing which excess military installations to close down to an independent commission, whose recommendations go into effect unless specifically voted down by Congress. The BRAC process—and others like it—works because it creates sufficient ambiguity about specific outcomes that objections are muted at the time of creation; the power of inertia then explains why the specific outcomes are allowed to take effect. For that second stage to work, it is essential that the proposals take effect automatically unless they are voted down by the Congress. This logic is reflected in the Independent Payment Advisory Board that was created as part of the health-care reform legislation to determine Medicare rates and rules.

Back to the Future, 2013 Version

So now back to our early 2013 hypothetical, in which we assume President Obama is re-elected and the House remains Republican. I say early 2013 on purpose, since I suspect the impediments to a deal will be more extreme during the lame-duck session at the end of 2012, before any of the tax expirations or sequestration cuts actually occur and while there may still be some maneuvering room to avoid the debt-limit bind. To the extent there is a serious attempt to get a deal done during the lame-duck session, the argument below still holds—albeit with a bit more force. (One factor that could change the dynamic substantially is if the debt limit turns out to be binding well before the end of the year—forcing a deal to occur in some form in 2012 rather than 2013.)

Given the overwhelming case for a major deal in early 2013, the difficulty of seeing how it could come together at this point only underscores the new political economy. It is not impossible to imagine, given the difficulty of passing bipartisan legislation and the distance between the Obama Administration and the House Republicans over tax policy in particular, that we will wind up with another “framework” agreement that leaves out specifics and delays decisions again, or alternatively a series of rolling temporary extensions of the debt limit and other provisions. That type of just-in-time governing would create unnecessary anxiety and uncertainty in an economy that is likely to remain weak relative to its potential.

In the grand negotiation to come (assuming that Obama and the House majority win re-election), supporters of the Obama Administration correctly note the leverage the Administration will have because all the tax cuts are scheduled to expire at the end of 2012. Note that if the middle-class tax cuts had been made permanent in 2010, this leverage would not exist, and the Administration would thus be facing another debt-limit dynamic similar to the one it faced in the summer of 2011. With the tax-cut expiration, by contrast, each side has leverage over the other—a fundamentally different dynamic, and one more likely to force both parties to the table. In other words, precisely because the Administration did not get what it wanted in 2010, the prospects for a significant deal in early 2013 are brighter—and that deal could well be broader in scope than anything that was possible in 2010. (In addition, the economy will have enjoyed some very modest benefit in the meantime from the meager additional stimulus provided by extending the high-income tax cuts for two years.)

The challenge is nonetheless that House Republicans will have to vote in favor of a debt-limit increase. The Administration’s success in pushing an extension of the payroll-tax holiday this past spring should not be seen as predictive of the 2013 mega-negotiation’s prospects, since the reason for that Administration win was that Republicans had somehow boxed themselves into a position—of appearing to oppose a tax cut—fundamentally contrary to their core views. In early 2013, by contrast, Republicans will again be fighting for tax relief—the ground they typically like to occupy.

One path through this brick wall for the Administration would be to allow all the tax cuts to expire and thereby escape the intractable debate over those extensions. In the cacophony that follows, the Administration could then come back in early 2013 with a tax-reform proposal that reduces taxes (compared to the level with the expired tax cuts) disproportionately for middle- and low-income families. If the tax cuts are designed to be universal, even if they are much more progressive than the Bush tax cuts, it would presumably be harder for Republicans to vote against them. One example of this strategy would be to combine a much larger payroll-tax holiday with an increase in the standard deduction. This would provide a substantial tax cut for everyone who works, but the effect would be progressive since payroll taxes represent a larger share of income for low- and middle-income workers than for high-income workers. As with the structure in place for the current payroll tax cut, general revenue would backfill the Social Security and Medicare Part A trust funds, so that the programs would not be harmed by the tax cut.

The problem with simply cutting payroll taxes is that it leaves out nonworkers, like the elderly. Therefore the second component of this proposal would raise the standard deduction, which is claimed by almost two-thirds of elderly filers. This component would also be progressive, since almost all high-income taxpayers itemize their deductions and therefore would not benefit from an increase in the standard deduction, and it would simplify the tax code by removing the need to itemize for more taxpayers.

By changing the discussion to a new tax proposal, it may be a bit easier to perpetuate a higher level of taxation on high-income families rather than continuing to debate the issue within the four corners of the Bush tax cuts. The tax cuts would be designed to avoid or minimize the fiscal contraction at the beginning of 2013, since the economy will remain too weak to handle a substantial fiscal tightening at that point. Ideally, however, even the middle- and lower-income tax cut within this strategy (the payroll tax holiday) would not be a permanent one, since over the medium term the federal government’s revenue base is inadequate for the tasks that have been assigned to it. So the significantly larger payroll-tax holiday could phase out as the labor market recovers. Middle- and lower-income families would be more severely affected by excessive reductions in existing government programs (like Medicare and Social Security) than a modest revenue increase to finance those programs.

That core tax package could be combined with other features. For example, we should reform the itemized deductions themselves. Many deductions are intended to promote socially beneficial activities, such as saving for retirement, purchasing health care, or owning a home. Yet with a deduction or exclusion approach, the tax benefit from spending $1 on one of these activities depends on the person’s marginal tax bracket. A person in the 15 percent marginal tax bracket who spends $1 on mortgage interest, for example, enjoys a 15-cent tax reduction from doing so; a person in the 35 percent marginal bracket enjoys a 35-cent tax cut for that same $1 in mortgage interest paid. This structure makes little sense from either a fairness or an efficiency perspective (as Lily Batchelder, Fred Goldberg, and I have argued in a Stanford Law Review article). A better approach would be to give each of these taxpayers, say, a 20-cent tax credit for each $1 in mortgage interest paid. Adopting this type of progressive approach to itemized deductions may require adding some less desirable policy—such as a second round of a corporate tax holiday on repatriated profits—to make the overall package legislatively feasible.

That broad approach may resolve the tax issue, albeit at the cost of some temporary turbulence, but it leaves open the debt limit and sequestration components of our early 2013 trifecta. Raising the debt limit and waiving the immediate spending cuts associated with sequestration will undoubtedly require entitlement changes. The question becomes whether the House Republicans accept the more modest entitlement changes discussed during the negotiations over the debt limit in 2011, or try to demand something more dramatic and problematic, such as block-granting Medicaid. The Administration would do well to aggressively combat the more radical proposals during the lame-duck session, lest it find itself boxed in unnecessarily in early 2013.

Before the critics start pointing out all the flaws in this strategy, it is worth emphasizing that none of the alternatives, including the one I sketch above, has an easy path to enactment. And that in turn underscores the key point: In a moderate-free Congress, it is much harder to govern—especially in a divided-government scenario. If nothing else, the likely drama later this year and early in 2013 will highlight the challenge of legislating in the new era of hyperpolarization.

 

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Issue #25, Summer 2012