Jack A. Goldstone, George Mason Univeristy

All that wrangling, fighting, and threats over deadlines (see my post “Lessons in Negotiation for Obama”) and we still get a credit downgrade.  Of course, that was the likely outcome when the debt ceiling deal just kicked the can further down the road, and made only paltry gestures toward the long-term budget adjustments need to create fiscal health.  Maybe this will be the shock needed to get serious negotiations going, and bring everyone to the table to compromise.  Or — worse outcome — Obama will be pilloried for being the President who “lost” America’s AAA rating, and will be weakened in future negotiations.

There is plenty of blame to go around, of course — I fault Obama for letting the debt-ceiling bill become an artificial crisis that distracted everyone from the much more serious task of long-term deficit reduction, and for not negotiating hard enough to get either a clean debt-ceiling bill or a much larger and more balanced package of deficit reduction.  I fault the Republicans for pushing for a balanced budget amendment that is dangerous and unrealistic, while at the same time refusing any kind of tax increases to make a balanced budget attainable in practice.

But let’s let the blame game go away (there are plenty of others who will continue to play it), and focus on what is necessary now to get America out of this mess that we are now all in.

First, we need a reality check.  We can never fix a problem if we either do not know what that problem is, or are in denial.   Here are some key facts:  The US population is aging — the number of Americans over 65 will double from 40 million to 80 million over the next thirty years, rising from 13% to 21% of the population.  There is no way that government spending for medicare and social security payments cannot increase somewhat as a portion of GDP, short of the reverse Swift solution (Jonathan Swift satirically suggested selling Irish babies for food to solve the Irish famine; his goal was to point out how severe the famine had become.  Unless we figure out a way to creatively dispose of our population once they reach 65 [Logan’s Run, anyone?] increased government spending on seniors is going to be with us.)  What we have to do is figure out how to meet our obligations to seniors but keep those costs from running wild and overwhelming the budget.  Simple caps or arbitary limits will not do the trick.  We need a serious reform of health care that will remedy the idiotic situation that the US has by far the highest and fastest rising health costs of any advanced economy.  We will need a serious adjustment of social security benefits to realistically reflect the major changes that have occurred since SS was adopted and last revised –that most seniors live longer, and have more alternative resources, than in prior generations.  Increases in the retirement age and means-testing for benefit levels must be part of the solution.

Second, we need to stop just assuming that the ‘growth fairy’ is going to return, wave a wand to restore 3.5% annual GDP growth, and bail us out of our debts.  In the last fifty years from 1960 to 2010, the US labor force (the population aged 15-64) grew by over 1% per year, growing by 86%; in the next fifty years to 2060, even with expected high levels of immigration, US labor force growth will be only 20%!  That is an annual growth rate of only 0.4% — we we are set to lose about .6% off of our past national economic growth rate just because of slowing population growth.

That means we will have to work harder to get back to historical levels of economic growth — it will take more investments in education and skill training and quality of infrastructure, not less.  (Figuring out ways to get more of world’s sharpest and most innovative and entrepreneurial immigrants into the US would be good too!).   And the competition will be tougher, from other advanced nations also seeking to grow out of debt and developing countries moving into fields where the US has been a major producer.  So we need a Sputnik-like level of attention to promoting our international competitiveness if we want to return to past growth.

Third, we need to stop accepting the lie that higher taxes mean less economic growth.  During the “Clinton Prosperity” from 1992 to 2000 individual income taxes paid rose gradually from 7.6% to 10.3% of GDP.  But that didn’t result in any economic disaster or slowdown — it produced a balanced Federal budget and steady economic and stock market growth.  Meanwhile, Federal spending fell from 22% to 18% of GDP.  Then in the GW Bush years from 2000 to 2008, individual income taxes paid fell back down to 8.1% of GDP.  And in the supposedly horrible, socialist, ‘blank-check’ Obama years, what do you suppose was the percentage of GDP paid in individual income taxes?  2009: 6.7% and 2010: 7.1% — the LOWEST fraction of GDP taken in personal income taxes since 1951!  So there is plenty of historical headroom to bring personal income taxes back up to the US ‘normal’ in the postwar period, which is in the range of 8-9% of GDP. (All Figures from Historical Tables: Budget of the U.S. Government)

But while personal income taxes can be raised slightly, future government spending must be sharply curtailed to return to a reasonable fiscal balance.  That is where the debate will be focused.

But why raise personal income taxes at all?  Especially since raising taxes on the rich will provide only a small part of the needed defict reduction?

One reason is to ask why the Bush income tax cuts were passed into law with an expiration date in the first place.  If the tax cuts were good, why was that necessary?  The reason why — as everyone has conveniently forgotten — is that the Bush tax cuts were timed to fit into a ‘window’ before January 1, 2011, which happens to be the date at which the first Baby Boomers hit age 65.

When the Congressional Budget Office ran the numbers, they clearly showed that the Bush tax cuts would not be sustainable once the Baby Boomers started to retire.  Up to 2011, the Baby Boomers would be paying large sums in to the government in taxes, and so we could afford a short-term cut in income tax rates without blowing up the budget.  But once they started to retire, stopped paying income taxes, and started to take money out in Medicare and Social Security payments, continuing the Bush Tax cuts would leave the government with a rapidly growing deficit that would create ever-higher deficits as far as the eye could see.  So the only way that the CBO would sign off on the Bush tax cuts is if they were set to expire at the end of 2010. Anything else would blow up the budget.  (And this was before the Great Crash of 2008).  So that is one reason to roll-back the Bush-era tax cuts — they would never have been tolerated in the first place, and made no sense, except in a specific window of opportunity that has now closed.

But an even more important answer goes back to principles of negotiation.  You can’t expect any one group to bear pain — and there will be, must be, pain to get back to fiscal balance — if other groups appear to be exempt.  That situation creates a situation of ‘if they don’t give anything up, why should I,” — a free rider problem to economists.  If some people are seen to be free riders, then everyone will try to free ride, and any agreement requiring shared contributions will fall apart.  Most of the pain from cuts in government spending and services, from Medicare to Social Security to Pell Grants and others, will fall far more heavily on middle-income earners than on the rich.  So rolling back the Bush tax cuts on higher earning households is one way to ensure that the public sees that everyone is sharing in the pain.

Of course, it is NOT the only way.  If we had a major and fundamental reform of the tax system to lower all rates and close loopholes, we could lower the basic tax rates on the rich as well, as long as they still were seen to be paying their share through higher marginal rates than those paid by middle and low earners.  But the principle is the same — ordinary Americans are facing a lot of pain, and there is no way they will accept it unless they see the best-off Americans accepting it and helping to share the pain.

So let’s get back to Erskine-Bowles and other reasonably realistic plans and figure out what to tax and what to cut.  There will be pain.  But if it is widely shared, we should be able to bear it and get America’s fiscal house in order.

Then, with a sound fiscal plan, government can start turning its attention to long-term growth-building investments, immigration reforms, and reductions in the level and growth rate of health-care costs — all measures that should further improve the fiscal picture for the future.

As my colleague Tyler Cowen says in his newest book, The Great Stagnation, America had a great run, but we got a bit sick; if we now take our medicine and rebuild we can get healthy again.