Insights on the Debt Deal with James Kwak of The Baseline Scenario

After extended ridicule from the media, US citizens, the international community, and each other, Congress has finally managed to collectively endorse a document claiming to be a deal on the debt ceiling. How far were we able to kick the can this time? We asked James Kwak, fellow at the Harvard Law School Program on Corporate Governance and co-author of the blogThe Baseline Scenario, where the United States stands after the weekend's debt shenanigans. Transcript below.

We saw this weekend Congress seems to have somehow muddled its way through the debt ceiling fiasco. What was interesting for you about the way that debate played out?

A couple of things. I think one is that the negotiations from beginning to end were dominated by an obsession with the top : the total government spending, and the total government tax revenue. On the Republican side, there was very strong insistence that no deal would include additional tax revenues because the fundamental issue for Republicans has been reducing the size of government, while naturally balancing the budget. One sign of this is that John Boehner and Eric Canter walked away from negotiations with President Obama that would've actually reduced the deficit by more then they ended up getting and the reason they walked away was because President Obama wanted “so-called” tax increases.

I think that on the one hand, the Republicans have been driven with this notice of keeping down the total size of government, then on the other hand, the reason they were so successful is that in negotiations it's actually good to limit your options going in. So, if you can credibly say I cannot compromise, you're more likely to win because the other side with have to compromise. The republicans were able to do this in part because the vast majority of the them signed a pledge not to raise taxes in any way.

Tell us about those “so–called” tax increases that you mentioned.

The point here is that Obama was proposing a different point and the Republicans complained that he didn't put his proposal in writing and that may be true. But, what he was supposing according to news reports was tax increases from anywhere between $800 billion to $1.2 trillion over ten years. But those are increases from a baseline that assumes that all of the Bush tax cuts would be extended and made permanent. The Bush tax cuts are scheduled to expire at the end of 2012.

And in fairness, right now we should be calling them the Bush-Obama tax cuts since they extended by the Obama administration. If those tax cuts are allowed to expire, they will bring in about $3.5 trillion in revenue over the next 10 years. What President Obama was potentially saying that part of this deal, I will allow you to make most of them permanent, I only want instead of $3.5 trillion, I only want $800 billion to $1.2 trillion. Compared to current law, this would have been a tax cut; compared to tax rates right now it would have been a tax increase. The Republicans weren't willing to go along with that and that's why we're in the situation we're in now.

What is the argument that they proffered? It's not just about this ideological question of smaller government, is it? There is a very real concern that any sort of tax increases at this time, given the feeble state of the economy, would be bad news, correct?

That's a valid argument. There are a bunch of economic issues that the country is dealing with right now. One is that the economy is very weak. I think second quarter growth was about one percent in real terms, and unemployment, as everyone knows, is over nine percent. By that argument, we should be doing more to stimulate the economy and many left wing economists will say we shouldn't even be talking about deficits and the debt and deficit reductions and austerity.

On the other hand, the issue that has been dominating Washington for the past few months is the deficit. What is interesting is you can pick one or the other to justify any argument you want to make and that cuts both ways. The Democrats can do it too. The Republicans have been a little bit more obvious about it saying that, well on the one hand, we have to cut spending because we need to bring down the long-term deficits, but on the other hand we can't raise taxes or we have to cut taxes in order to stimulate the economy today.

Of course, you could say exactly the opposite on both of those and you would still be saying something that was logically plausible. I think that the argument for not raising taxes is not crazy. But, I think if you're going to say your top priority is the deficit and that has been the state of position of most but not all Republicans, then it would seem to make logical sense that you should be willing to consider tax increases. In particular, one issue is that taxes come in different forms. For example, we have an income tax with marginal tax rates up to 35 percent right now and there is a credible argument to be made that if you increase those tax rates, then that will reduce the incentive for people to work, and that will hurt the economy a little bit. But we also have these things called tax expenditures, which are essentially loopholes and some of them are very popular loopholes like the home mortgage interest deduction. If you want to eliminate some of those loopholes, you would not only get more tax revenue, which would reduce the deficit, but you would also reduce the impact of government on society.

So if you are a true Libertarian, someone who thinks that government should have less influence on people's economic decisions, then you should want to kill these tax expenditures. This is because home mortgage tax deduction, at the margin, makes a person buy houses who wouldn't have bought houses otherwise, that's government interference in the economy. I think that some Libertarians will agree with that argument but the Republican Party, as a whole was not even willing to consider loophole closures that would've increased revenue.

So stimulating the economy through tax loopholes, is that something that has come up in Congress at all? I don't recall seeing much debate about that recently.

Well, stimulating the economy is often done by creating tax loopholes and by creating preferences in the tax system. For example, I think this one goes back to 2000, I'm not sure how long this one goes back, but we have these things in the tax code now called investment incentives, which essentially allow business to write off the cost of investments faster than they would have under ordinary accounting principles. Those things get extended all the time because those things expire in 2012 and they will get extended again.
When Congress wants to stimulate the economy it has a few options. It can increase direct government spending as with the 2009 stimulus bill. That has become politically impossible in today's climate. It can reduce taxes, just cut taxes across the board. For example, in 2008 when the economy was beginning to weaken, the bi-partisan stimulus package of 2008 essentially involved mailing checks to people. It can also create more focused tax incentives like credits for certain kinds of business activity. There are all kinds of goodies that Congress has to give away. What has happened in our political system though is that because of the political pressure against increases in spending, tax cuts have been the solution for any economic problem,

The best example of this is last December, Congress added $900 billion to the national debt through a tax cut compromise. Essentially what happened was the Democrats wanted certain tax cuts and the Republicans wanted certain other tax cuts and they compromised by giving everybody all the tax cuts they wanted. Now seven or eight months later we are here complaining about the debt ceiling which again we just added $900 billion dollars to the debt. And it's the exact same people doing this, which many people have noted before.

Is this just a negative consequence of the doctrines that are pushed from either side of the aisle in Congress? This idea that it's all cuts and there is no other method for stimulating the economy.

I think that it's a couple of things. First of all, the stated goal was to reduce the deficit, not to stimulate the economy. The arguments about stimulating the economy. A lot of Democrats or Democratic economists have been saying we should be focusing on jobs, not on deficits. They will completely moved to the side because of the debt ceiling debate. The government was going to run out of money to pay its bills sometime probably in the next week and a half, its not clear. The treasury department has been insisting that we would have run out of money tomorrow on August 3.

Other analysts have said that they think we have until about August 10. But because of the debt ceiling, the Republicans have had the upper hand procedurally because whenever the debt ceiling needs to be increased, it is on the President to essentially keep the government functioning. So, the Republicans were able to use the upcoming debt ceiling as a way of making sure that deficit reduction was the top item on the agenda, not jobs.

Then you get down to the question of should we cut spending or should we increase taxes? The two positions in the debate were the Republican position, which said it should be all spending cuts, and President Obama's position that it should be about two-thirds to three-quarters spending cuts and one-quarter to one-third of tax increases. You can already see in a sense how far that President Obama has shifted towards the Republican position on that issue.

If you look at opinion polls, a majority of Americans will say that the deficit should be reduced through a combination of spending cuts and tax increases. Having said that, if you give people three options, all spending cuts, all tax increases, or a combination, people will naturally just pick the one in the middle. So, I'm not sure how much we should trust those polls. We had a debate that was over what seems like an extreme position to what seems like a moderate position. We actually ended up at the extreme position in the end.

A lot of these spending cuts that were agreed upon are not even for spending that exists yet, correct? It is just projected spending that is going to be cut in the future.

Yeah, that's correct. The deal is somewhat complicated, but what they've agreed to so far is the caps on discretionary spending that collapse in the next ten years. A couple definitions for your listeners. Discretionary spending is spending that Congress has to authorize every year. For example, every year the budget for the Securities and Exchange Commission has to be approved by relevant congressional comities.

Theoretically, Congress could say, “Your budget is zero for next year,” and you don't exist anymore. That is what is being capped by these spending caps so what they looked is what the congressional budgeting office calls baseline projections. In their baseline projection, I believe that discretionary spending increases at the rate of inflation. Essentially what they did in the budget agreement is they said, we are going to take that path of discretionary spending and subtract about $100 billion a year. So it is cuts to spending that hasn't happened yet.

That brings up an important point, which Ezra Klein mentioned on his blog, which is that after all of this, after all of the negotiations, the showdown, the standout, the eleventh hour compromise, the two parties agreed to very little. If you think about it, the Democrats wanted tax increases and the Republicans didn't concede on that point. The Republicans wanted cuts in entitlement spending—social security, Medicare, Medicaid—and they didn't get any of those either. They just compromised on discretionary spending caps, which were the easiest thing to agree. Then they agreed on a process by which some other group of people is going to have to figure out another set of spending cuts or potentially tax increases.

So, you're right, they haven't really made a cut out of the long-term deficits. They kicked the ball down the road and the hope is that this joint committee of Congress is going to be able to come up $1.5 trillion in deficit reduction. But, there isn't a lot of reason to think that the conditions for the negations which will happen in October-November will be different from the conditions we've had the past two months.

Right - even with this deal that supposedly been worked out, we don't know where Congress is going to be in 2012 or 2014. Isn't there a possibility that all of this could be just scrapped? Where actually have we gotten after this weekend?

Well, the most important thing we have after this weekend is the government is not going to default at least until sometime late next year. President Obama most important request was an increase in the debt ceiling that would get us past the next elections. Obama was asking for $2.4 trillion and, under certain conditions, he will only get $2.1 trillion in debt ceiling increase. It's very complicated what happens later this year. As Mitch McConnell, Senate majority leader, quoted in a memo to his members in the senate, he said “If certain things happen, Obama will only get $2.1 trillion and this issue will come back before the election next year.”

But in any case, that's the main thing we have gotten. We have gotten a joint committee that is supposed to study the issue and make recommendations. The way the agreement works there is supposed to some very strong incentives for them to find ways to reduce the deficit. In particular for example on the Republican side, if they cannot come up with a plan to reduce the deficit that is agreed upon by Congress, then there will be automatic major cuts to defense spending. That is supposed to be the trigger.

What concerns me about that arrangement is that the trigger list time was the federal government defaulting on its debt. If both sides were willing to go up to 24 hours before the federal government defaulting without essentially conceding anything significant, its not clear to me next time will be anymore powerful. Aside from keeping the government functional, we haven't really gotten much. If you're a Democrat or a liberal Democrat who thinks we should be investing more in jobs, the economy, and infrastructure, then we certainly haven't done that.

If you're a Republican who thinks we should have lower taxes, then they haven't gotten to that, they haven't gotten assurance that the Bush tax cuts will be extended. Bush tax cuts are not apart of this deal at all. They've gotten reductions in federal spending that are actually quite modest. I think that a lot of the news reports said that both sides were unhappy with this deal and they have reason to be unhappy because there certainly isn't a lot in it.

Are you concerned about the increasing polarization we are seeing between the two political parties on coming to agreements on things like this? Neither side got what they wanted and the whole thing was just a big farce.

It does seem that way doesn't it? The increased polarization in Congress has certainly been a problem. It has been a problem for the last twenty years. If you go back to the 1980s and the early 1990s, deficit reduction was actually generally a bipartisan thing.

A little bit of history, in 1981, Ronald Reagan introduced the largest tax cut of all time. We also had a recession, big increase in defense spending, and deficits went up. Reagan and the Democrats agreed on deficit reduction packages that included tax increases three times in the 1980s. President Bush, the first Bush, in 1990 agreed with the democrats to raise taxes. The first time we had a real budget standoff that was completely on partisan lines was in 1993 when President Clinton's tax increase for the 1993-1994 budget was passed with zero Republican votes so it was complete party line vote. Then in 1995, we had the government shutdowns.

Anyway, this is the problem that goes back a ways and the many causes for this-- gerrymandering districts, influence of money in politics and so on. I think on the other hand in a sense it's not something you can do about or something you can really blame either side for. Obviously, I sympathize more with the Democrats on these issues, but if I think about it from a Republican standpoint, if you're a conservative Republican and your goal is to cut taxes, reduce the size of the federal government, and reduce federal spending, you have this debt ceiling.

I believe this debt ceiling should not exist, but it exists. You have this tool you can use and in your mind you are using this tool to achieve an outcome, which is better for the American people and the country as a whole. I can't really fault you for using every trick in the book and every weapon you've got to achieve your ends. That's the Congress we have these days.

What I think that was new this time and a little disturbing is that there certainly a minority of the Republican caucus that was willing to let the government default and actually thought that would be a good outcome. Rand Paul and some other Senators basically said defaulting is one way to balance the deficit and that is better than increasing the debt ceiling. There is certainly a small group of Republicans who were not going to vote for any debt ceiling increase under any circumstances. That group of Republicans is still pretty small and right now, John Boehner and Mitch McConnell are essentially able to keep the votes for this compromise. But that attitude, the attitude that we can just let government default and everything will be okay is just dangerous and that is certainly something to watch in the years to come.

If the next elections give us more people who would rather see the government default, then we could have some serious trouble ahead.

Posted in: Baseline Scenario, debt ceiling, deficit, James Kwak


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