Editorial Board

Three Steps Toward a Grand Bargain on the Federal Budget: View

Prompted by the looming expiration of the debt ceiling, President Barack Obama and both parties’ congressional leaders say they have made progress on a deal that sets the course for shrinking the federal budget by $4 trillion over 10 years, with a mix of tax increases and spending cuts, including from the big entitlement programs. Also on the table is an overhaul of corporate and individual taxes.

This has all the makings of a grand bargain to reduce the national debt -- if the president and lawmakers, who plan to meet over the coming weekend, can pull it off. Already, the parties’ political bases are looking to slow down any deal that would cut entitlement programs (angering staunch Democrats) or raise taxes (alienating conservative Republicans). They should be ignored, and not just because the pain has to be spread. It’s just not possible to find enough savings in the discretionary portions of the federal budget alone.

With that in mind, here are a few guiding thoughts for a deal:

First, any tax-code overhaul should end the hundreds of loopholes, subsidies, deductions and credits for corporations and individuals. The goal should be a tax system that’s simpler, raises more revenue and doesn’t serve as a back door for the government to spend money it doesn’t have.

The biggest tax expenditure, an estimated $260 billion a year, is the exclusion for employer-provided health insurance. There are bigger exclusions for employees in higher tax brackets. The result is the government picks up more of the cost of insurance for well-paid workers than for those earning less. The budget negotiators should end that privilege.

Mortgage Interest

The deduction for mortgage interest, costing $79 billion a year, encourages consumers to overborrow and spend too much on housing. A Bloomberg National Poll last month, showing that rising numbers of Americans favor eliminating the deduction as part of a broader tax-reform effort, indicates it could be politically feasible to phase this out over the coming decade.

The lower tax paid on long-term capital gains is another break that should be reduced or eliminated. It’s hard to see why workers should pay a top rate of 35 percent on wages while investors pay just 15 percent on their profits.

In addition, Obama and Democrats are correct in wanting to target some longstanding tax breaks, most of which are the result of special-interest lobbying. Over 10 years, ending the 15 percent rate that applies to carried interest -- the profits earned by managers of private-equity firms and some hedge funds -- would generate $20 billion; abolishing a provision that rewards companies that use last-in-first-out, or LIFO, accounting for inventory costs would raise about $70 billion; the elimination of subsidies for oil and gas companies would yield about $40 billion; ending tax breaks for corporate jets would generate $3 billion; and phasing out deductions for taxpayers earning more than $500,000 a year could bring in more than $200 billion.

Ending Loopholes

Ending a long list of loopholes and a few tax expenditures, however, won’t raise enough new money to truly pare back the debt, now $14.3 trillion. To do that, negotiators should allow the Bush-era tax cuts to expire on schedule at the end of 2012 for the most affluent Americans. Allowing the rates for individuals earning more than $200,000 annually and married couples making more than $250,000 to return to levels that were in effect under President Bill Clinton would save about $700 billion over 10 years.

Second, any serious effort to trim federal spending must also take a hard look at the bill for Medicare, which last year amounted to 3.6 percent of gross domestic product, or about $530 billion. Because such a large share of the population is aging, the cost is expected to rise to 5.5 percent of GDP by 2035. But the Medicare trustees estimate that long before then -- by 2024 -- the trust fund will be exhausted.

Means Testing

One way to bring down the cost is to ask affluent older Americans to pay more for their health care. This strategy, known as means testing, is already used in Medicare’s prescription-drug program and its coverage of doctors’ services; higher-income Americans pay larger premiums and receive fewer benefits.

A proposal being offered by independent Senator Joseph Lieberman of Connecticut and Republican Senator Tom Coburn of Oklahoma would cap out-of-pocket expenses at $7,500, but raise that amount for the affluent -- by up to $15,000 for individuals with incomes above $160,000. Coburn and Lieberman would also ask older Americans who make more than $150,000 a year to pay the full cost of their premiums for drugs and doctors’ care.

Finally, budget negotiators should use this opportunity to fix Social Security. The program’s trustees say the pension fund will run dry in 2036. A simple way to begin shoring it up is by changing the formula for cost-of-living adjustments to more accurately measure inflation.

The government now uses the standard Consumer Price Index, but the Labor Department and many economists say that overstates inflation by not reflecting product substitutions most consumers make when prices rise. A better index, called the “chained CPI,” mimics the ways that consumers keep their expenses steady by, say, switching to bananas when the cost of oranges goes up. The Congressional Budget Office estimates the chained CPI will grow about 0.3 percentage point a year slower than the normal CPI, saving about $100 billion over 10 years.

These reforms have enough bipartisan support to fit into a deal. They might not fit comfortably, they might not change American lives overnight, but they’ll allow the country to escape the catastrophic embarrassment of a default on its obligations. And they’ll certainly put the U.S. on a path to a sounder economic future.

    To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net .

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