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What's Wrong With the Republican Fiscal Cliff Counteroffer

House Republicans are out with their response to the President's opening bid on the fiscal cliff, and it's not very impressive. Here are three big problems with the letter they sent to the White House:

1. It's not really a proposal -- it's just a set of headline numbers without specific policies. The letter says Republicans want to cut $900 billion from mandatory spending and $300 billion from discretionary spending, but they don't say what or how they want to cut. The letter nods toward a proposal sketched out by Erskine Bowles, the cornerstone of which is a gradual increase in the Medicare age, but it lacks specifics.

On the tax side, they agree to $800 billion in new revenue from "pro-growth tax reform that closes special-interest loopholes and deductions while lowering rates." But they don't endorse specific loophole closures or propose a new rate structure.

Last week, the President put forward a reasonably specific list of policies. He didn't just propose to raise $1.6 trillion in new revenue and cut $400 billion from mandatory spending over ten years. He proposed specific changes to tax rates and deductions to produce the new revenues, and the entitlement cuts are laid out in his budget (most of the savings come from reductions to Medicare provider payments). Republicans didn't like those proposals, but this letter is not responsive to them.

2. The description of tax reform makes little sense. It's feasible to raise $800 billion from base broadening over ten years, but not to raise $800 billion and finance a significant cut in tax rates. Even if you capped all itemized deductions (including for charity) at $25,000, that would only generate about $1.3 trillion in new revenue, leaving $500 billion available to finance rate cuts.

At current rates, individual income tax can be expected to raise about $16 trillion over the next ten years. So, $500 billion in headroom would allow a roughly 3 percent (not 3 percentage points) reduction in tax rates; that is, the bottom rate could go from 10 percent to 9.7 percent, and the top rate from 35 percent to 33.95 percent.

Beyond restricting itemized deductions, there are a couple of other ways to raise a lot more revenue through base broadening, neither of which the Republicans are likely to support. One would be to eliminate tax exclusions for health care and not replace them with a comparable subsidy, which would massively disrupt the health care market. Another would be to eliminate or sharply reduce the tax preference for capital gains and dividends.

Now, maybe Republicans plan to go aggressively after the charitable deduction and are willing to take a very small rate cut. Or maybe they've decided capital gains tax rates can go way up. But it's more likely they're engaging in Romney-style tax policy, where you pretend you can have several things that are not simultaneously possible. If Republicans are serious about getting new revenue out of the fiscal cliff deal, they will have to give up the dream of rate cuts.

3. The proposal does not fully avert the fiscal cliff. Republicans describe their proposals as a way to "avert the fiscal cliff." But this proposal would only partly delay the implementation of austerity measures (tax increases and spending cuts) into future years when the economy is stronger.

Some parts of the Republican approach to cliff aversion are clear. The plan would continue the vast majority of the Bush tax cuts. I assume Republicans would agree to generally uncontroversial items: patching the Alternative Minimum Tax, implementing a "doc fix" to prevent a sharp drop in Medicare reimbursement rates, and extending corporate tax provisions that require periodic renewal.

But the $1.2 trillion in "sequestration" spending cuts wouldn't be averted; instead they would apparently be replaced by other cuts to entitlement programs and discretionary spending. While mandatory spending cuts (such as a Medicare age increase) would likely be backloaded by design, Republicans need to make clear that they are willing to backload the discretionary spending cuts, too; otherwise, they will constitute a near-term austerity measure.

The letter also says nothing about the payroll tax holiday or extended unemployment insurance benefits, both of which Republicans likely want to sunset. As such, this proposal only constitutes a partial aversion of the fiscal cliff, which would mean a drag on economic growth in 2013.

(Josh Barro is lead writer for the Ticker. E-mail him and follow him on Twitter.)

Read more breaking commentary from Bloomberg View at the Ticker.

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