Avert Fiscal Cliff With Entitlement Cuts, Tax Increases

Oct. 3 (Bloomberg) -- How long does the U.S. have before the bond market demands much higher interest rates on Treasuries, forcing a sudden and painful belt-tightening on every American? For a sense of the answer, tune in a week or so after the presidential election.

That’s when Congress reconvenes to decide what to do about the expiring tax breaks and across-the-board spending cuts that take effect in January. Combined, they equal about 5 percent of the economy.

This time, the capital markets may be in no mood for a solution that merely postpones everything. Failure to modify the tax increases and spending cuts, however, would almost certainly induce a recession. And if all the scheduled tax increases take effect, consumers would get crushed. The Tax Policy Center reported this week that the average increase for middle-income households would be almost $2,000.

Luckily, a bipartisan coalition of people in and out of government has been trying to figure a way out. The outlines of a consensus are emerging. With the business community providing political cover, some Republican lawmakers are willing to split with their party’s no-tax-increase dogmatists, but only if they get entitlement reforms in return. Democrats in the group seem willing to slow the growth of Social Security and Medicare -- programs the party tenaciously protects -- so long as they get tax increases in return.

You can see where this is going: Tax revenue in exchange for entitlement cuts offers the best hope. The challenge is to give each side enough incentive to withstand a backlash from its partisans.

There are many ways to do this. The plan by the president’s Simpson-Bowles deficit commission is one. But Paul Ryan, the Republican vice presidential nominee, is right: It doesn’t contain enough health-care savings. President Barack Obama and House Speaker John Boehner cobbled together a $2.3 trillion package, before their talks fell apart last summer, with $800 billion to $1.2 trillion in new taxes and $400 billion in Medicare and Medicaid savings. It might be a better starting point.

Any deal must slow the growth of entitlements. Program cuts should be phased in, allowing short-term increases for education, public works and research -- programs that improve the U.S.’s competitiveness. The savings should add up to $3 trillion over 10 years ($4 trillion when already-enacted savings are included).

The mix should be about 3-to-1 spending cuts to tax increases. Congress needn’t come up with the whole enchilada in a post-election session. Before leaving for the holidays, however, it should at least pass a down payment -- and a timeline for completion of the hard work.

Finally, members should swallow a poison pill if they don’t adopt a package by August 2013. One option: Let the Simpson-Bowles plan take effect if Congress misses its deadline.

Revenue Neutrality

Can it be done? As always, the hardest part will be getting Republicans to raise taxes. But even Mitt Romney, the party’s presidential nominee, says he might tax the rich more. Romney recently mused out loud that he would limit taxpayers to $17,000 in deductions; that could mean a hefty tax increase for the rich, depending on the details. With that in mind, here is a suggested 10-year road map:

-- Raise the retirement age to 69 from 66 by indexing it to longevity. Adding one month every two years would bring it to 69 in the year 2075. Eligibility for Medicare benefits should also rise. Savings: $249 billion.

-- Require more Medicare cost-sharing. Congress could discourage overuse by increasing deductibles and co-payments. It could also means-test Medicare benefits so that the well-to-do elderly pay more. Savings: $353 billion.

-- Shrink COLAs. The Consumer Price Index overstates the cost of living by not accounting for the cheaper product substitutions consumers make when prices rise. A better index, the “chained CPI,” captures such behavior. Savings: $232 billion.

-- Raise taxes on the wealthy. The Bush tax cuts should be allowed to lapse for household earnings above $250,000, returning the top marginal rates to those under President Bill Clinton. Congress should also adopt the Buffett rule, requiring millionaires to pay at least 30 percent in income taxes. Savings: $740 billion.

-- End corporate tax breaks. Many deductions and exclusions serve no public purpose. We would end the 15 percent rate on profits earned by managers of private-equity firms. Other options include abolishing a tax break for last-in, first-out inventory accounting and cutting oil and gas subsidies. Savings: $160 billion.

-- Overhaul other government programs. Congress should eliminate some farm subsidies, reform the military pension system, require federal employees to contribute to their pensions at levels similar to private-sector workers, and have the U.S. Postal Service go to five-day delivery. Savings: $213 billion.

These actions alone would produce two-thirds of what is needed. They would cut $470 billion from Medicare and $570 billion from other domestic programs. The tax increases equal $900 billion. Closing more tax loopholes, raising rates on investment income, extending Medicaid drug rebates to the Medicare drug program and revamping the Defense Department could produce the remainder, and possibly leave enough room to lower tax rates.

The U.S. has paid extremely low rates on its debt for several years now. Net interest last year totaled 1.5 percent of gross domestic product, half what it was in 1997. The U.S. benefits from its status as the healthiest horse in the glue factory. But with $11 trillion in public debt, or about 73 percent of output, that privilege won’t last. It wouldn’t be prudent to test the market’s patience.

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