This is a rather long post. It tries to put into a clearer perspective the highly publicized impending end-of-year budget and tax events – called “taxmageddon” by some in the press. It takes the position that as imposing as these legal developments are on paper, a short-sighted Congress and White House could work their way around the consequences – but only in the near term. The budget time bomb continues ticking. What are the fundamental elements needed for a new President and Congress to take this problem on? We close with a few observations.
You surely have heard of the extraordinary budgetary events that lurk in the nation’s tax and spending law, just waiting to spring out upon us at the end of this year. The list is long, and frankly frightening.
In the previous decade, temporary laws involving hundreds of billions, even trillions of dollars became highly fashionable. Then with the financial paroxysm at the turn of the decade, the Congress and the President enacted more temporary legislation to provide near-term stimulus to the economy. The former actions were based on the assumption that robust economic growth would continue forever; the latter assumed that after the recession, the economy would bounce back vigorously. Both of these assumptions have proved wrong. So now, what were once presumed to be routine extensions or expirations of temporary laws have become major policy dilemmas.
Some see the “perfect storm” or “taxmageddon” at the end of this year as a likely occasion to take on the budget problem. This optimistic view holds that when confronted with all of these issues, elected policymakers finally will get religion and solve the problem once and for all.
I am highly skeptical – not that a change of heart should happen, but that it will, given recent patterns of behavior. But there is so much at stake that we need a clear view of the next year or so. Let’s start with an inventory of the dangling issues.
Expiring Provisions ‘R’ Us
Here are the major policy expirations (and other triggered policy changes) that the nation will face on New Year’s Eve, 2012:
- The tax cuts passed in 2001 will expire.
- The tax cuts passed in 2003 will expire.
- A long list of additional temporary tax reductions – probably most notably the research and experimentation (R&E) tax credit for businesses – will expire.
- The temporary inflation adjustment to the individual alternative minimum tax (AMT) expired on January 1, 2012 – which means that it will affect taxpayers when they file their 2012 tax returns in early 2013.
- The economic-stimulus temporary payroll tax reduction, which has been in effect since the beginning of 2011, will expire.
- The temporary extension of the duration of unemployment insurance benefits will expire.
- The Medicare “doc fix” – postponing reductions in physician reimbursements that were mandated in the Balanced Budget Act of 1997 – will expire. As of January 1, 2013, Medicare payments will decline by about 30 percent.
- Automatic spending cuts of about 9 percent on annually appropriated defense spending, about 7 percent on annually appropriated non-defense spending, and limited cuts on selected mandatory (“entitlement”) programs, will take effect.
The combined effect of all of these expirations will be to increase taxes and decrease spending by several hundred billion dollars in 2013. It will be more than large enough (relative to the nation’s GDP) to be felt throughout the economy – while the economy quite likely will remain vulnerable (given weakness in Europe, extreme slack in the housing market, and high gasoline prices) to pressures toward a renewed economic slowdown.
So Between Now And The Election, What Will The Congress Do About This Scheduled Policy Train Wreck?
Well, not precisely nothing. Fiscal year 2012 ends on September 30 of this calendar year. So the Congress will have to act to prevent a government shutdown (which would not play well with the voters). However, do not look for actual appropriations to be passed for the next full fiscal year. The Congress likely will pass yet another short-term bill – a “continuing resolution” at the current levels or slightly below – extending past the election, but expiring before Christmas. They may increase the nation’s debt limit at the same time, or they may bunt that decision on the next Congress.
How can the Congress be so blasé about all of these consequential – to say the least – economic policy developments?
The fundamental issue is that the two political parties have diametrically opposite views about how to solve our economic problems. For example, Democrats believe that increasing government spending stimulates the economy. Congressional Republicans say that reducing government spending stimulates the economy. It is hard to find a principled compromise between “no” and “yes.”
And with an election just around the corner, and with the other side both in control of part of the policy-making apparatus of government yet so totally wrong-headed, why compromise? Instead, just wait until you sweep the board in the election, and then you can solve the problem your way.
Both sides are sure that they will gain ground in the election. (Footnote: Democrats realize that they face a real challenge in the Senate, largely because they must defend so many seats newly won six years ago.) Each side believes that its cause is right, and that it is right on the issues. Furthermore, the outcome is down to performance in office, and each side is convinced that they have done the best possible job. After all, politics is their profession. (They will remain convinced that they will win until the handwriting on the wall is crystal clear. You will know that moment because news stories will begin to appear with anonymous sources blaming others in the same party for the impending defeat.)
And even if the likely winners were willing to cut a deal (which they won’t be), what good would it do for the other party to make concessions? It would infuriate their core voters, and the winners would simply come back and take even more with their greater strength after the election. Better to draw to an inside straight – with at least some chance of winning – than to concede something up front.
So each side will refuse to deal until the last minute, both because they will believe that they will win and get a better deal later, and because they want to maintain the loyalty and enthusiasm of their bases – who are by definition the ideological extremes in the two parties. In the last moments when it becomes obvious that one side should compromise and salvage whatever they can, it will become equally obvious that the other side would be foolish to concede anything before they take full control. We will go to the polls on election day with nothing resolved – in fact, with respect to the annual appropriations, with even more of the government’s fiscal policy poised to expire within weeks.
Will The Lame Duck Hobble To The Rescue?
Because the Congress will have massive unfinished business, it will need to reconvene after the election, but before the new Congress is seated in January. (In the olden days, when Congresses largely passed their appropriations bills on time, such post-election sessions were usually unnecessary.) So that short session will include a number of non-returning Members – or “lame ducks,” as they were called.
Some believe that even after continued policy failure for most of this year, the clouds will part and the sun will usher in an Age of Enlightenment – like the fifth movement of Beethoven’s “Pastoral” Symphony – with the coming of the almost certain “lame-duck” session of the Congress this year. Representatives and Senators who have failed to achieve reelection – and others who have chosen to retire – will suddenly be freed from servitude to their political bases. For the first time, they will be able to vote their convictions and consciences with impunity. The political center will congeal, once unthinkable but essential actions will be taken, and the budget problem will be solved. The lame-duck Members will limp toward the sunset, warmed by the thanks of a grateful nation, and all will live happily ever after.
Uh, no. Lame-duck sessions are among the worst experiences in a life in the Congress. All Members are exhausted. Defeated Members are miserable. The business of the Congress is – quickly – to usher out the old and install the new. Defeated and retiring Members are shuttled almost instantly from their offices to remote locations where they share desks and cubicles with limited – if any – privacy. Being much farther from their committee hearing rooms and from the floors of their chambers, they confront practical problems in trying to do their work. In an “old-normal” election year, with the work of the Congress largely completed, this would not matter much. In this “new-normal” year, it will be a major impediment.
Departing Members are reminded (they already knew, but may have forgotten) that the career workers who manage the Congress – the people who move the furniture, install the telephones, handle human resource questions, and so on – understand very clearly that the departing Members are departing, and have no remaining power over their work lives. In contrast, the incoming Members – who must be fully installed and up to speed barely eight weeks (including the holiday season) after the election, will be the new determinants of day-to-day happiness for the permanent staff, from the Capitol Police to the cafeteria workers. The entire institution – personal friendships aside – turns its back on the outgoing Members, not out of cruelty, but by instinct.
The disruption and chaos is not fully measured by the number of departing Members (noting that the current public dislike of the Congress suggests that turnover could be substantial). The departures trigger a musical-chairs process through which Members bid, by seniority, for vacated office space. Because retiring Members are often the most senior, prime space is likely to open up, cascading down to slightly less-senior Members one by one; with each decision to take a new office, another space opens, and another move takes place. In the end, numerous returning Members of all ranks move. The halls are filled with chairs, desks, and boxes, and the noise is continuous.
Congressional staff members, often highly senior and with considerable responsibility, find themselves unemployed. They have spouses, children, and ambitions to feed. If they have lost their jobs because their bosses’ philosophies have gone out of fashion, the markets for their accumulated knowledge may be thin. Conditions are especially painful for some if control of either chamber changes hands. Committee staff positions are often allocated in a ratio of two for the majority for every one for the minority. Every former majority staff must downsize enormously. Even the staffs of returning Members and those retained by committees are miserable, because their friends who have lost jobs are looking desperately for help.
The complication in the lives of the staff – particularly the staff of the departing Members – slows the work of the entire Congress. Displaced staff members are looking for new jobs, and if they find jobs, they take them. Once ushered out of their old offices, they have no real place to work anyway. So departing Members who want to get something accomplished are either without the staff members on whom they have relied, or often cannot find them, or cannot find a place to work with them in a productive way. (This is not a knock on Members because they are “dependent” on their staff. The best Member offices and committees have strong teams, where everyone contributes significantly. Their absences are felt for all of the right reasons.)
And even while the Congress tries to finish its old business, it is beset with new business. Leaders of the victorious party maneuver for personal power, while the leaders of the losing party try to protect their positions, and others try to oust them. Among the players in this drama are the new Members, not the former ones. It distracts the ending Congress’s deliberations enormously.
In sum, a lame-duck session is not the optimal environment in which to negotiate and write complex legislation resolving the crucial and hitherto insoluble problems facing the Republic. And in particular, defeated and retiring Members of Congress are not well situated to change their career-long positions on the most difficult issues (which the vast majority of those Members – though possibly not all – still hold intensely) and drive the public debate to a successful conclusion of principled compromise. In fact, in recent experience, the apparent highest priority of the “lame ducks” has been to get out of town.
Post-election politics is unlikely to render a lame-duck session more productive. If either party should achieve control of both chambers, there will be no reason to compromise; that party will simply wait until it has more power next year. This will be true especially if that party also takes the White House.
This is not to say that a successful lame-duck session in 2012 is impossible or inconceivable. There are seasoned Congress and White House watchers who envision particular alignments of the planets under which certain focused deals could be struck. As an economist practicing politics without a license, I must concede some space to the experts in that field. But I believe that it would take a miracle for us to see a fundamental attack on our structural budget problem between Election Day and New Year’s Rockin’ Eve. (Those who long have said that it will take a miracle for us to get out of this fiscal mess may or may not be encouraged by that statement.)
But What About That Scheduled Train Wreck?
Some who read these suppositions will immediately react, “Wait a minute. All of those terrible expirations of tax cuts and automatic spending cuts will happen on January 1, 2013. The Congress and the President can’t just walk away from that. Surely they will have to do something!”
Yes, they will have to do something. But that “something” does not need to extend to a fundamental change in our fiscal policy. (It should, but it does not need to – if the sole criterion of success is making it through the night.) In fact, the bare-minimum requirements for legislation (to which this Congress always seems to retreat) are quite limited.
The Congress will need to pass another continuing resolution to extend the fiscal year 2013 appropriations from whenever they expire in November or December through into the new calendar year. There will be some brinkmanship played over the level of those appropriations. But because no one wants to be held responsible for a government shutdown, even almost two years before the next election, the two sides will cut a deal to pass another continuing resolution that will extend into the new Congress and the new Administration.
The Congress probably will need to re-enact the “doc fix,” postponing yet again the cut in Medicare reimbursement rates for physicians. But this might not be difficult, because both parties are committed to do that anyway. And for that matter, probably few physicians serving Medicare patients are credit-constrained. If the President and the Congress stated a firm commitment to extend the doc fix retroactively, physicians might possibly tolerate a short period in early 2013 when their reimbursements would be temporarily low but assuredly would be made whole later. The same is true of many expiring tax provisions; the R&E tax credit has expired and been reinstated retroactively before. The payroll tax holiday and the extended duration of unemployment insurance would be problematic. But Republicans generally do not like the payroll tax holiday, and even more strongly dislike the extension of the duration of unemployment benefits. The Congress might struggle over those provisions, but in the end might just give up.
But that’s it. That is all this Congress needs to do in its lame-duck session.
But doesn’t that mean that tax rates will go up on January 1? Won’t income tax withholding go through the roof? Won’t that tank the economy? Yes, but no and no.
Technically, income tax rates will go up on January 1. However, income tax withholding from wage and salary income is not set by law. It is set by the Secretary of the Treasury. As a matter of course, Treasury Secretaries have set withholding rates such that most taxpayers are over-withheld, because the worst possible outcome is to have many financially unsophisticated taxpayers obligated to write big checks when they file their tax returns in April.
But suppose that the President(-elect) announces in late 2012 that, yes, the tax cuts are scheduled to expire at the end of the year, and the tax rates are going to go up, but he and his team are confident that, with the new Congress (possibly under the control of his party), the law will be changed. Accordingly, he has directed his Treasury Secretary(-designate) to leave wage and salary withholding rates unchanged until further notice.
The President would be fully within his legal rights to do so, as would the Secretary to comply with this directive. The only downside would be if the Congress were to dither and finally to fail to extend the tax cuts, so that many middle-income taxpayers might find themselves under-withheld. But how many Members of Congress want their fingerprints on a tax increase for middle-income families? Leaving wage withholding unchanged seems like a safe bet for a President of either party.
Footnote: Taxpayers whose income comes from property rather than work do not have withholding, but rather pay in quarterly installments. The first quarterly installment against calendar year 2013 income tax liability will be due on April 15, 2013. So those taxpayers can heed the President’s advice, watch and wait until next April, and then decide what they believe will transpire. Within limits, if subsequent congressional action fails and their April 15 estimates prove to be low, they can make up the difference by increasing their next (June 15) payments, and avoid any tax penalty. So they, like wage earners, can postpone the effects of the expiration of the tax cuts until the situation is resolved.
But what about the automatic spending cuts – the “sequester” – that will take effect on January 1? The automatic spending cuts, mandated by the debt-limit deal last August as a fallback in case the “Supercommittee” failed (it did), are a little bit trickier. However, they too have an administrative remedy – admittedly imperfect, but largely effective.
Most (but not all) of the automatic spending cuts will be imposed upon annual appropriations. Money from annual appropriations is “apportioned” to the various agencies periodically for parts of the fiscal year. With the automatic spending cuts in place, an apportionment for (say) the first quarter of calendar year 2013 would have to reflect the expected automatic spending cut.
But if the President(-elect) believes that he and his fellow party members in the Congress can change the law in some way later, he can circumvent the sequester by apportioning to the agencies all of the remaining spending authority for the full balance of the fiscal year as of January 1 (or 21, depending on the election outcome), 2013. The President(-elect), through his OMB Director(-designate), can inform the agencies that he expects the sequester to be replaced by an alternative policy, and so they will be allowed to spend at higher rates (which the Director would determine) until the issue is resolved. Because OMB is the legally designated arbiter of compliance with the sequester, there should be no problems with this maneuver with respect to annually appropriated spending. (A much smaller part of the sequester applies to mandatory programs, including a maximum 2 percent reduction in Medicare reimbursements. Getting around that part will be trickier, and may not be possible; but it is, again, much smaller than the cuts in annual appropriations.)
Other elements of “taxmageddon” pose different problems. Trickiest probably is the expiration of the inflation-indexing fix for the alternative minimum tax, which occurred on January 1, 2012. Thus, tax returns due on April 15, 2013 would have to reflect the expiration and resulting tax increase unless the Congress acted quickly at the beginning of 2013. However, literally no one in the Congress advocates allowing the AMT to expand in that fashion, and so a quick fix in the early days of the year should be feasible. The other tax extenders are less troublesome. As was noted earlier, the Congress has in the past allowed the R&E tax credit to expire, and then has re-enacted it retroactively.
In other words, if the ambition of the Congress and the President is merely to avoid making waves, there is very little that they need to do – other than explaining themselves and their actions in press releases – before the end of this calendar year. They have been kicking the can down the road for some time, and now, upon close examination, it seems that the road is a little bit longer than previously thought. The ultimate constraint on this can-kicking habit is the reaction of financial markets. The markets are not perfectly predictable. However, with the economies and finances of Japan and the nations of Europe continuing questionable, the United States could retain its status as the best looking horse in the glue factory despite this kind of manipulation of the end-of-year fiscal “crisis.”
This scenario makes clear that the budget problem need not “solve itself” through expired tax cuts and automatic spending cuts, as some would suggest. For some reason, maneuvering around supposed legal requirements is in the DNA of our society – witness tax shelters, and health providers recovering Medicare reimbursement reductions by performing more and slightly different services, among other phenomena. And if push comes to shove and the Congress cannot avoid imposing pain on the voters by circumventing the law, the one subject on which the two parties regularly can come together to change the law is bestowing benefits – be they tax cuts or spending – to key constituencies. Like a fluid leak in an automobile, the deficit and debt problem will not solve itself. The nation will have to act to solve it.
But What If We Aim Higher?
This rather cynical guide to what the nation and its elected policymakers can get away with is emphatically not a prescription for what we should do. We should take the fiscal problem seriously, and address it immediately. However, we’re not. I am not a betting person (and $10,000 is well beyond my feasible stakes), but if forced with a gun to my head, I would bet that action in 2012 will come close to the drive-by scenario described above.
Even in 2012, but certainly in 2013, there always is the possible “economic crisis” – the “therapeutic heart attack” that would motivate us to mend our ways. But we already have had an economic crisis – the worst recession and financial near-meltdown since the Great Depression – and that was not enough to move our leaders into action. And as mentioned above, Europe and Japan continue to make our fiscal behavior look good by comparison.
So short of a surprise, successful guest appearance by the Ghost of Christmas Yet to Come, what could steer this process toward a sound fiscal future as we move into 2013?
Briefly, the new Congress and the President need to conclude that the problem is urgent. This is not to say that we collect a large tax increase and cut spending effective tomorrow, but rather that we get to work on a fiscal plan that commits to deficit reduction on a sound macroeconomic-policy schedule – with the effect of the program quite possibly delayed for a year or more, but enacted into law now to demonstrate our commitment.
For these purposes, my definition of “urgent” would be that both sides accept in January that the problem cannot wait until after the next election. Politicians always believe that they will win. Our side always will be stronger two years from now. But if the Congress is in the hands of one party and the Presidency the other at the beginning of the next presidential cycle, it may be clearer that the likely wait of four years, rather than two, would be too long. And if economists and budgeteers can make the case that risks are growing, the two parties might reconcile themselves to the need to cut a deal. Clearly, even if nothing happens in legislation this year, advocates of fiscal sanity have a lot of work to do.
And the reasonable heads within the two parties need to recognize that each party must save the other from itself. Democrats must recognize that they cannot solve the problem solely by taxing the “rich” and ending a war that already is ending. Republicans cannot do the job just by cutting regulations, food stamps, and taxes on “job creators.” Both sides must understand that compromise means that you give something, but also that you get something. All of the good ideas from both sides will be needed. So a square deal would give some victories to both sides – and possibly save the nation from a financial disaster.
Our leaders can continue to maneuver around the letter of the law – but quite probably not the laws of physics, or of supply and demand in the market. At some point, the markets will lose patience with our nation’s fiscal behavior. We must change course before they do. Early 2013 might not be our last chance. But then again, it might be.