14 Dec 2012 Is Compromise Possible?

The US economy likely slowed substantially in this current quarter under the weight of political uncertainty. The best clue comes from Federal Reserve Chairman Ben Bernanke who said, “Clearly the fiscal cliff is having effects on the economy,” he said, referring to the combination of expiring tax cuts and scheduled spending cuts set to begin early next month. “This is a major risk factor right now.”

Bernanke’s remarks followed the Open Market Committee’s final meeting for the year on Wednesday and made Fed history by publishing a threshold at which they would adjust interest rates. Mr. Bernanke said the Fed didn’t expect to touch short-term rates until they saw the unemployment rate fall to 6.5% or lower, as long as inflation forecasts remain near their 2% target. That would mean, according to the Fed’s economic projections, that it would keep short-term rates near zero into 2015.

So as the mighty US economy nears stalling speed, her divided leadership seems more intransigent than ever. President Obama simply demands higher taxes on the rich while Speaker Boehner refuses to yield unless the president offers substantial and specific spending cuts. Here’s the rub as pointed out by E.J. Dionne of the Washington Post and Peggy Noonan of the WSJ: For the president, “the deficit is not the highest national priority, economic growth is. He will favor spending to pump up the economy, not cuts that will take the air out of it. The president does not want to cut spending. He wants to increase it. He wants to raise taxes on the wealthy, as he defines them. He does not want the government to be smaller but bigger, or, as he’d probably put it, as big as it has to be.”

It’s not just about politics, Noonan says, though it is crystal clear that Mr. Obama would like to crush his political foes, particularly with the strong tide of public sentiment with him. “And it’s not about economics per se—he knows raising taxes on the rich will not solve our fiscal problems. He’s seen, as he likes to say, the math.”

Moreover, “what is motivating him primarily is ideology. And an ideological opening. He doesn’t like the malefactors of great wealth. He wants to ‘spread the wealth around,’ as he told ‘Joe the Plumber’ in Ohio in 2008. His ideological and political affinities are with those he defines as the needy, and his answer to them is to see they are the focus of greater public spending. Period.”

On the other side of the argument stand House Speaker John Boehner and an ideologically-charged Republican House majority who believe they have common sense and historical fact on their side. To them taxes are the very brakes of economic growth. Increasing them is a sure-fire way to send the economy into recession or worse.

There are two distinct groups in the argument for taxes; the so called ‘middle class’ and the so called ‘rich.’ The middle class provides the most significant part of the consumption of American and global products and services. Consumption represents nearly three quarters of our economy. Taxing money from their pockets means less spending and a slowing or shrinking economy. This outcome is what both sides obviously want to avoid.

The less-obvious threat of higher taxes and, I believe, just as vital for our economy is this ideological mantra of taxing the rich. While a few wealthy business leaders have invited the increases, they DO NOT speak for the large portion of the, let’s say $250,000 to $1 million dollar earners who are small business owners reporting their business income as part of their personal taxes. These small business owners create some 60% of the jobs created by small business which as a larger group create 70% of all new jobs in the US. Anyone who would argue that job creation and business activity would not be impacted negatively if Congress takes another 5% or 10% or 15% of their profits would be economically if not intellectually challenged.

But the first round of tax increases may just be the opening salvos from a big-government administration and Democratic party who so far appear unwilling to cut entitlements to any extent. Ed Conrad of Politico observes that debt relative to GDP cannot be allowed to rise forever. Since 2007, government spending has increased over 30%. It has gone from an historical average of 20% of gross domestic product to 24%. Government revenues (taxes) have remained flat in the face of these mammoth increases in spending opening up an unprecedented $1.1 trillion-a-year in deficits.

To hold debt constant to GDP Conrad says “we can sustain deficits of about $200 billion a year (as the economy grows). Today, that leaves a $900 billion-a-year gap between revenues and spending. Letting the Bush tax cuts expire on upper-income taxpayers raises less than $50 billion a year (that’s 4.5% of the problem solved). Limiting deductions to 28% of income for upper-income taxpayers, raising capital gains and dividend tax rates to ordinary income tax rates and raising estates taxes together would raise less than $100 billion a year more. Reasonable changes to Medicare and Social Security, such as raising the retirement age and raising upper-income Medicare premiums, would raise much less than $50 billion a year more.” He goes on to say that ending the Afghanistan war would save about $150 billion a year, but Obamacare increases spending by that similar amount, even after its tax increases and Medicare cuts. And compounding the problem is the demographic fact that the number of workers per retiree will soon drop from 3-to-1 currently to 2-to-1.

Here’s where it gets really ugly for those of us who care about the legacy we leave for our children and grandchildren. Conrad points out that unless the president and Democrats really get serious about government spending, they cannot pay for their spending “without draconian across-the-board tax increases. Even the fiscal cliff — which would raise middle-class taxes hundreds of millions of dollars a year by letting the Bush tax cuts expire for all taxpayers, expose them to the alternative minimum tax and end the payroll tax holiday — would close only two-thirds of the fiscal gap. The need for dramatically higher revenues makes the president’s threat to veto any legislation that does not raise taxes on investors by the end of the year credible. How better to raise taxes on the middle class than by going over the fiscal cliff and successfully blaming the resulting tax increases on Republicans?”

Conrad concludes with a dire warning: “As if their negotiating position was not precarious enough, it will grow increasingly difficult for Republicans to hold the line on tax increases. When the middle class and seniors realize the truth, they are going to fight hard to maintain their incomes by increasing taxes on investors even further. Investors who thought a 39% tax rate was acceptable are in for a rude awakening. Even with tax increases and spending cuts from the fiscal cliff, we still would need a 70% marginal tax rate to close the $900 billion-a-year gap. Recent history shows that’s hardly outside the realm of possibility. Not but 30 years ago, marginal tax rates were that high.” A fellow by the name of Ronald Reagan came along to reverse the tide of spending (for four years anyway) starting what would be the greatest bull market in US history.

In truth, there is no compromise between big and small government ideologies. A slight majority of the country voted for larger government and that is what the administration and Senate are trying to give them. If they refuse to negotiate with the House of Representatives who represent the slightly smaller half of the country that wants smaller government, then we shall sail over the cliff and everyone gets a quick taste of austerity.

Republicans in the House and Senate are many and they are somewhat divided ideologically and practically. They face a single ideological individual, who so far has been singular in his message and unyielding (at least publically) in his negotiating position. If the Republicans back down and cave into his tax demands, it is now obvious that they will be forced to do so again and again, and perhaps forced ever closer to their own cliff of irrelevance.

In an inspiring article in today’s Wall Street Journal A Brief History of American Prosperity, Guy Sorman wites “In the current sluggish economic environment, the remarkable history of American dynamism is thus more instructive than ever. America’s economic might is rooted in an entrepreneurial culture and a passion for innovation and risk-taking, traits nourished by the nation’s commitment to the rule of law, property rights, and a predictable set of tax and regulatory policies. Policymakers have lost sight of these fundamental principles in recent years. The next era of American prosperity will be hastened when they return to them.”

To this observer, it looks increasingly likely we are going over the cliff. The president’s comment today that “The idea of not raising taxes has become sort of a religion for a lot of members of the Republican Party” was meant as taunt to paint his opposition as ideologues, not willing to compromise, when in fact it is he who has been unwilling to offer anything to the negotiations. Mr. Boehner’s comments of late have indicated anything but progress saying that there were “serious differences” between the two sides. And he made it clear yesterday that he was not about to back down by saying that “Congress will never give up our ability to control the purse. The fact is that the debt limit ought to be used to bring fiscal sanity to Washington.”

In an ironic twist, Congressional observers say that next Thursday (coincidentally, the date of the Myan apocalypse) is the drop-dead date for a any agreement to effectively get through both houses of Congress and onto the president’s desk to be signed into law. By December the 22nd, we should know.