Link U.S. Payroll Tax Holiday to Unemployment Rate: Peter Orszag

June 30 (Bloomberg) -- Today’s fiscal policy debate straddles two divides: one between those who support jobs and those who favor austerity, and one between those who think additional revenue is needed and those who don’t.

On the first divide, both sides are right, because the truth is that the U.S. needs both jobs and austerity -- and a combination would be more powerful than either piece by itself. We face a very weak labor market now and, over the medium- and long-term, an unsustainable fiscal path. It would make sense to combine an additional round of temporary job creation measures with a substantial amount of permanent deficit reduction that would be enacted now but take effect later.

The economy remains weak after the bursting of the credit bubble 2 1/2 years ago. In 2007, total private sector borrowing amounted to roughly 28 percent of gross domestic product. By 2009, it was 17 percent of GDP. History shows that economies take substantially longer to recover from this type of financial crisis than from other shocks. Yet we continue to be surprised that our expectations for growth are not realized. (Our two biggest Charlie Brown moments thus far were in late 2009-early 2010 and late 2010-early 2011.)

What’s most likely ahead is a prolonged period of relatively slow growth, less than 3 percent per year (The International Monetary Fund shares this outlook.). And, unfortunately, that means the unemployment rate will decline only very slowly, if at all.

Long-Term Joblessness

Lasting weakness in the labor market, in turn, can cause people to lose their attachment to the workforce and see their skills atrophy. Already, 6.2 million Americans have been unemployed for more than six months, and 4 million for more than 12 months. We thus face the problem continental Europe experienced during the 1980s, when a temporary downturn there led to stubborn unemployment and more workers collecting disability benefits.

Given our feeble labor market, it is particularly important that policy makers avoid overly hasty deficit reduction. Official projections for the federal budget show fiscal tightening in excess of 2 percent of GDP from fiscal year 2011 to 2012. To put that percentage in context, consider that the fiscal tightening in the U.K. from 2010 to 2011 -- which has received so much attention in the news media -- amounted to less than 1.5 percent of GDP.

To mitigate the harm to the labor market from this fiscal drag, policy makers should provide additional macroeconomic support in 2012 by extending the existing payroll tax holiday. But more than that, Congress should link the payroll tax to the unemployment rate. This would allow the tax holiday to automatically calibrate itself to existing conditions, providing support only when the economy is weak. If necessary, the underlying payroll tax rate could be raised to make this mechanism budget-neutral.

Lower the Deficit

Such additional macroeconomic support shouldn’t be enacted alone, however, because we must also address our unsustainable long-term fiscal course. Even though it would be wrong to reduce the deficit immediately, it is essential that we enact measures now to lower it over the next decade and later.

This brings us to the second divide over fiscal policy: between those who support raising revenue and those who don’t. Here again, timing matters. It is difficult to see how the 2015 deficit problem can be addressed by cutting spending, and equally difficult to see how the 2050 deficit problem can be addressed by raising revenue.

First, the 2015 problem. As the economy recovers, the deficit is projected to decline from about 10 percent of GDP to 5 or 6 percent. This projection, by the way, assumes a more robust recovery than may occur in the wake of a financial-led recession. To the extent that the recovery is sluggish, the deficit will be higher.

Seeking Stability

Stabilizing debt as a share of the economy requires a deficit in the range of 3 percent of GDP. So even if the official assumptions turn out to be right, we face a gap in 2015 between the projection and the size of deficit that would give us a stable fiscal trajectory.

Given the inevitable phasing in of any changes to entitlement programs, it is difficult to see how, by 2015, spending cuts could reduce the deficit more than about 0.5 percent of GDP. To make a difference in the next few years, more revenue is needed.

There is no easy way to obtain this revenue, unfortunately. Among the difficult choices, the best approach is to reconsider the tax cuts of 2001 and 2003. They should be extended only if they can be offset by other measures. If not, they should be allowed to expire in full. That requires only 34 votes in the Senate. It also has the benefit of familiarity, because it would return the tax code to roughly its form in the 1990s, and it would raise roughly enough revenue to stabilize the debt over the next decade.

Spending Cuts

The 2050 deficit problem is different. Over the long run, most of the fiscal adjustment will have to come from reducing expenditures. We simply can’t raise enough revenue to offset projected spending increases.

Those increases are disproportionately due to health care. The Congressional Budget Office reports that by 2050, spending on Medicare, Medicaid and other federal health programs will rise from 5.5 percent of GDP to more than 12 percent. By comparison, Social Security costs are projected to increase from 5 percent of GDP to 6 percent over the same period.

The bottom line is that, right now, we need jobs measures and deficit reduction that would take effect as the economy recovers. From 2015 to 2020, we’ll need more revenue. And looking ahead over the next four decades, we have to contain costs, especially in health care.

(Peter Orszag is a Bloomberg View columnist. The opinions expressed are his own.)

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