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.

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.

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