Perspectives

Also see our Economic Commentary which supplements the Laufenberg Economic Quarterly and primarily focuses on more recent economic developments.

European financial affairs have been in the news recently. In 2010 Dan wrote an essay on Greece and the European Union which you may find interesting and still relevant. Go here to read it.

This page is designed to offer you my perspective on economic fundamentals, ranging from business cycles to yield curves. It will provide more detailed economic analysis than is generally available in the Quarterly. For the most part, the essays provided here will attempt to discuss timely fundamental issues related to the forecast but are expected to have a longer shelf life than the content on either the Quarterly or Commentary pages. I hope that over time you will consider the information on this page as a source of reference when debating economic issues in the future.

Daniel E. Laufenberg, Ph.D.
LaufenbergQuarterly.com

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Going over the "fiscal cliff"
(November 2, 2012)

The U.S. economy, as specified under current law, is heading for a so-called “fiscal cliff” of federal spending cuts and substantial tax increases at yearend. The “cliff” aspect of this event, according to the Congressional Budget Office (CBO), is that the fiscal tightening is so massive that it could push a somewhat lethargic U.S. economy into what most likely would be considered a recession. Since we have never been in this situation before, it is unclear exactly how it will play out. It could happen the way the CBO estimates, but it would be frustrating to see the economy slip into a recession when it could be avoided. It is almost as if politicians are playing a dangerous game of “chicken” with the U.S. economy; that is, the two sides of the political aisle are driving the economy toward a cliff hoping the other side will surrender. I am confident that politicians understand that no one benefits if the U.S. economy going over the cliff. Indeed, there is a good chance that such an event could do permanent damage to the U.S. economy in terms of future productivity gains Although I expect policy makers to avoid the cliff, this viewpoint does not favor a particular school of economic thought but rather a small dose of common sense.

I am not suggesting that Congress should postpone addressing the federal deficit and debt issues indefinitely, but it seems appropriate to postpone them until they can enact a more gradual approach to deficit reduction than the one scheduled for yearend. After all, as long as the economy grows, the federal budget deficit as a percent of gross domestic product (GDP) will decline even if the current tax code remains in place owing to structural changes to the economy. For that reason, it would be political suicide to push the economy into a possible recession, but it also could be political suicide to ignore the deficit problem in the long run. I contend that if policy makers do not address the growing federal debt issue soon, bond investors will require much higher interest rates. And the Federal Reserve will not be able to stop it. Clearly, the dilemma for policy makers is trying to walk the thin line between the need for near-term fiscal stimulus and long-term deficit reduction.

Although I am concerned about the possible impact of the fiscal tightening at yearend, I am not convinced that it will lead to the recession projected by the CBO. For one thing, the CBO’s analysis seems to assume that consumer spending increased dramatically in response to the earlier tax cuts and as such will plunge in response to the upcoming tax hikes. However, the tax cuts enacted since 2001 were always subject to sunset provisions, suggesting a transitory nature of the after-tax income gains. To the extent that consumers considered the gains in after-tax income as transitory (the permanent income hypothesis of consumer spending), it would suggest that they most likely saved more than they spent. Under these circumstances, consumer spending most likely will not take the massive hit projected by the CBO; the scheduled tax increases will reduce saving more so than spending.

For this reason, I believe the CBO’s economic forecast overstates the adverse effect of the cliff on economic growth in 2013. That being said, going over the cliff still will be a drag on the economy in early 2013, which still may be something worth avoiding in the current economic environment. In this case, postponing the fiscal tightening until something more gradual can be worked out makes sense—but it must not be postponed indefinitely.

Finding a solution to the deficit problem is politically challenging because it requires compromise, which at the moment seems to be in short supply. We all want tax rates to be as low as possible, but at the same time they need to be high enough to pay for the government we want. And we want the tax code to be fair. I am not talking about socking it to the rich. I am talking about two households of equal size that make the same income paying roughly the same total federal taxes, including both federal income and payroll taxes. I personally would like to do away with payroll taxes and increase income taxes accordingly. Both taxes are paid out of income, except the former is only assessed on earned income.

For the most part, the entitlement programs that payroll taxes fund are nothing more than income transfer programs anyway (and often intergenerational income transfers at that). As such, it seems to me that this type of government expenditure more so than any other should be funded by a progressive tax. Hence, the tax should be imposed on all income and not just earned income. Not only are payroll taxes regressive (the effective tax rate for low-income workers is higher than the effective tax rate for high income workers), but they also penalize earned income relative to other types of income.1 This creates a tax incentive to avoid earned income if possible, which is something that only the very rich can do with some ease. For example, Warren Buffet, according to his 2010 federal tax return, made $62,855,038 in gross income but apparently only his salary (earned income) of $100,000 was subject to payroll taxes. In most households, the bulk of their income is earned and therefore subject to both income and payroll taxes. Apparently in 2010, I paid more Social Security and Medicare taxes than Warren Buffet.

Next, I attempt to assess the potential impact on the economy if we go over the cliff. In this case, I also will examine the scenario I think is most likely if not always most favored; we postpone the changes until later.

What is the fiscal cliff?

In this essay, I try to define in some detail the fiscal cliff. To do so, I rely heavily on analysis by the CBO. Under current law, substantial changes in tax and spending policies are scheduled to take effect in January 2013. This combination of tax increases and spending cuts are projected by CBO to reduce the budget deficit by a total of $487 billion in 2013, with most of the improvement coming from higher taxes.

First, the Budget Control Act of 2011 specified automatic procedures to reduce both discretionary and mandatory spending during the coming decade. Those automatic reductions will take the form of equal cuts in funding for defense and nondefense programs in fiscal years 2013 through 2021. For 2013, those reductions will be achieved by automatically canceling a portion of the budgetary resources (in an action knows as sequestration) for most spending programs. However, the law exempts a significant portion of mandatory spending from sequestration. In particular, the provisions of the Budget Control Act limit spending cuts in most Medicare benefits to 2 percent and exempt Social Security and Medicaid from sequestration altogether. The bottom line is that in 2013, the CBO estimates that the automatic reductions in spending will total about $110 billion, evenly split between defense and nondefense spending. Recall that the highly advertised reduction in spending of nearly $1 trillion, divided equally between defense and nondefense spending, is for the 2013-2022 period.

The CBO estimates that total revenues to the federal government as a percent of gross domestic product (GDP) will increase from 15.7 percent in 2012 to 21.4 percent in 2022, with the bulk of the increase coming over the next two years and led by the expiration of a number of tax cuts enacted since 2001. With regard to individual income taxes, certain tax provisions that were initially enacted in 2001, 2003, or 2009 are scheduled to expire at the end of December 2012, returning many aspects of the current income tax to rules that were in effect more than a decade ago. Moreover, the higher exemption amounts that have mitigated the impact of the Alternative Minimum Tax (AMT) since 2001 expired at the end of December 2011. CBO projects that the resulting increase in tax liabilities stemming from the AMT in 2012 will be paid almost entirely in 2013.

One thing to keep in mind is that tax revenues as a percent of GDP most likely would increase even if statutory tax rates and tax credits remained unchanged, owing to real bracket creep (higher real incomes push more taxpayers into higher tax brackets), the AMT applying to a growing share of incomes as nominal income rises, and rapid growth in taxable distributions from tax-deferred retirement accounts as the population ages. CBO estimates that these factors would increase revenues as a share of GDP by an estimated 1.7 percentage points over the next decade. Moreover, CBO assumes that as the economy continues to improve, certain components of taxable income, especially wages and salaries, will rebound faster than the economy as a whole, increasing federal income tax revenues relative to GDP by about 1.0 percentage point between now and 2022.

In other words, of the 5.7 percentage point increase in total revenues as a percent of GDP over the next ten years estimated by CBO, only about half of it is due to the expiration of tax provisions enacted since 2011. The “cliff” aspect of this analysis is that the bulk of the revenue gains attributed to the tax provisions expiring occur over in 2013 and 2014.

Possible impact on the economy from going over the“cliff”

Anticipating what the impact of going over the cliff would be for the U.S. economy is extremely difficult. If the assumptions are that current law remains in place, then it is very likely that the cliff with its combination of spending cuts and tax increases would be a substantial drag on the U.S. economy in the first half of next year. The CBO’s baseline forecast as reported in its mid-year report actually projects a recession in 2013 if current law is not changed.2 Owing to the significant fiscal tightening set to go into effect in January, CBO projects that real GDP will contract by 0.5 percent over the four quarters of 2013 after growing 2.1 percent in 2012. CBO says that real GDP will fall at an annual rate of 2.9 percent in the first half and then it will rise at an annual rate of 1.9 percent in the second half. Under this scenario, the unemployment rate will rise, but inflation and interest rates will remain low. Indeed, most of the adjustment to lower budget deficits would occur in 2013. Beyond then, the CBO projects that real GDP will average 4.3 percent growth over the 2014-2017 period, before slowing again to an average of 2.4 percent from 2018-2022.

An interesting aspect of the CBO projection is that even if some or all of the fiscal tightening scheduled under current law was removed before the end of the year, the real economy would grow in 2013 but at a very sluggish pace. In this case, the unemployment rate most likely would remain high if not go higher. In other words, even if Congress acted to remove the fiscal tightening scheduled for next year, the CBO still expects the U.S. economy to underperform its potential by a considerable margin.

I doubt anyone is surprised that my forecast for the U.S. economy is somewhat less pessimistic in the near term but probably less optimistic beyond 2013 than the CBO forecast. The difference is that in my baseline case I do not have to assume that current law remains unchanged. In fact, I assume that the cliff will be postponed in order to give the new Congress time to find a more gradual deficit solution. And I assume that such a solution will be reached sometime in 2013; that is, a much milder version of fiscal austerity than under current law. In this regard, I actually expect real growth to be better in 2013 than it probably will be in 2012.

In my August forecast, I projected real GDP growth of about 2.7 percent over the four quarters of 2013, following a gain of 2.3 percent in 2012. Since then, real GDP growth in the second quarter has been revised downward to 1.3 percent from the initial estimate of 1.5 percent and real GDP growth in the third quarter came in at 2.0 percent rather than my forecast of 2.3 percent. As such, my forecast for real GDP growth over the four quarters of 2012 has been revised downward slightly as well to 2.1 percent. It is quite clear that the drought probably took a bit out of real growth (in the form of less farm inventory accumulation than normal in the fourth quarter), as well as the increased likelihood that Tropical Storm Sandy will zap real GDP growth a bit in the fourth quarter. However, in both cases, any lost output in the fourth quarter will be added back in the first half of next year, with most of it showing up in the first quarter.

On balance, I expect the U.S. economy, even if the fiscal tightening scheduled in January is allowed to occur, to avoid a recession next year. Clearly fiscal drag will take some away from the economy in the first half, but it will not be enough to offset the positive momentum in consumer spending and housing, as well as the bounce from the clean-up following Tropical Storm/Hurricane Sandy and from output in the farm sector returning to normal (the end of the drought).

Many agree that deficit reduction actually could be a good thing. The question is whether taking steps to cut the deficit aggressively in the near term may in fact exacerbate the problem longer-term. Clearly the preferred way to balance the budget is through strong economic growth, which in turn generates more jobs, taxable income, and tax revenue. Unfortunately, growth cannot do it alone, and certainly not in 2013. Over time, real economic growth means real tax bracket creep—as real income grows, it pushes taxpayers into higher tax brackets. The inflation adjustments to brackets protect taxpayers from higher nominal incomes due to inflation but not from higher real incomes.

The other factor that will push revenues as a percent of GDP higher over time, all else the same, is the aging population. In particular, an increasing share of taxpayers will be faced with mandatory distributions from 401K plans or IRAs as they reach the age of 70-1/2. This will generate tax revenue on income that was deferred earlier, causing taxable income to increase faster than GDP. Indeed, these two items could be worth an increase of as much as 1.7 percentage points of revenue to GDP over the next decade.

Unfortunately, even if the economy was operating at full employment, there still would be a sizable budget deficit suggesting that it is very unlikely that the economy can grow enough to get the federal government out of its budget mess. For that reason, some austerity is expected and maybe even preferred.

Offering my version of budget reform

I do not have a detailed solution to the federal deficit problem, but rather general principles that any budget reform proposal should follow. On the spending side, all government outlays are classified as mandatory, discretionary spending and net interest. In fiscal year 2011, mandatory spending totaled $2.03 trillion or about 55.8 percent of all outlays. Net interest represented another 6.4 percent of the total. The implication is that mandatory outlays and net interest costs represent over 62 percent of all outlays. This means that less than 38 percent of all outlays are discretionary.

Mandatory spending includes any liability of the federal government that needs to be paid because recipients satisfy the eligibility conditions to qualify for benefits. This would include Social Security, Medicare, Medicaid, and any other automatic government spending program. Net interest includes the cost of servicing the federal debt outstanding.

My general principle with regard to spending is that the mandatory spending component and the net interest component of the federal budget be required to balance every fiscal year. The reason is that such payments generally represent the transfer of income from one group to another. However, this transfer should be allowed only if the taxpayers financing the transfer have the income to do so. In other words, the federal government should never borrow to pay for transfer payments, much like state and local governments are prohibited in most cases to borrow to pay for operations. Recall that state and local governments segment their budgets into operating or capital expenses. They can borrow for capital purposes but not for operating purposes. Maybe we should limit the federal government such that it can borrow only to fund discretionary spending and never mandatory or net interest outlays. In this way, every year policymakers in Washington would be required to make the connection between government borrowing (more debt) and discretionary spending decisions. Increased mandatory spending would require a corresponding increase in tax revenue. If policymakers were unable to agree on a tax increase, then any borrowing by the federal government would be assigned to the discretionary side of the ledger. I believe that this would impose a greater level of discipline on politicians when it came time to expand mandatory programs or raise the level of debt outstanding, especially in a rising interest rate environment.

Another aspect of reform might be to convert entitlement programs to means-tested programs. The government would still provide a safety net for the truly needy but not entitlement programs for everyone. In fact, if we had to choose among government sponsored entitlement programs, I would pick health care over retirement. We have more control over the latter than the former.

On the tax side, most economists agree that higher taxes are a necessary part of any solution, although there is considerable disagreement on how the tax increases should be administered and distributed. It goes without saying that high-income households should pay more taxes than low-income households. The disagreement is about how much more—proportionally more or progressively more. Whatever the decision, it needs to be packaged in a tax proposal that the general public perceives as fair. That may be the more difficult aspect of the assignment than actually raising taxes. One way to do this is to broaden the tax base to include more income rather than just a general hike in tax rates. After all, the question is not whether we all pay taxes because we do in some form or another, but rather that we pay the appropriate amount given our income.

In 2009, the most recent data available from CBO, the average federal tax rate—that is, households’ federal tax liabilities divided by their income (including transfer payments) before taxes—was 17.4 percent in 2009 for all households and ranged from 1.0 percent for households in the lowest quintile to 23.2 percent for households in the highest quintile (and to 28.9 percent rate for households in the top percentile). A few caveats are required at this juncture. First, Table 1 shows total federal tax rates, which includes the tax incidence on households, as estimated by CBO, of federal individual income taxes, payroll taxes, corporate taxes, and excise taxes.3

table 1

Moreover, the overall average federal tax rates of 17.4 percent in 2009 were the lowest in the 1979–2009 period and were well below the previous low of 19.4 percent in 2003 and the average for the entire period of 21.0 percent. For most income groups, the 2009 average federal tax rate also was the lowest observed in the 1979–2009 period. The exception was the top percentile, which had a lower average tax rate in 1985 than they did in 2009. It is important to note that this tax incidence is for federal taxes only. It does not include state and local sales, real estate, or income taxes.

If we narrow our analysis to just the federal individual income tax, it provides an even more interesting aspect of tax incidence. As shown in Table 2, much of the progressivity of the federal tax system is derived from the individual income tax. In 2009, the bottom quintile’s average rate for the individual income tax was -9.3 percent—that is, refundable tax credits actually exceeded the income tax owed by that group. On average, households in the second quintile also received more in refundable credits than they paid in individual income taxes. The average income tax rate was 1.3 percent for the middle quintile, 4.6 percent for the fourth quintile, and 13.4 percent for the highest quintile. The top 1 percent, on average, paid 21.0 percent of their income in individual income taxes. Clearly, the individual income tax is used not only to collect government revenue but increasingly over the last 23 years, it also has been used to reallocate income. This was most evident in 2009 in which the average individual tax rates for the bottom two quintiles of income were negative.

table 2

The average individual income tax rate is typically higher than the average payroll tax rate, but in 2009 it was lower. Two factors explain that unusual result. First, because the tax base for payroll taxes is limited to earned income, a steep drop in nonwage income (such as interest, dividends, and capital gains) reduced income taxes but not payroll taxes in 2009. Second, the American Recovery and Reinvestment Act of 2009 (ARRA) made several changes that lowered individual income taxes in that year. The act introduced new refundable income tax credits and expanded existing ones. The CBO measured individual income taxes net of these refundable credits.

Because average federal tax rates rise with income, the share of federal taxes paid by higher-income households exceeded their share of before-tax income, and the opposite was true for lower-income households. In 2009, the shares of federal taxes paid by households in certain income quintiles were 0.3 percent for the lowest quintile and 67.9 percent for the highest quintile. For the three quintiles in the middle, their share of federal taxes paid totaled 31.8 percent. There is little doubt that the higher income households pay a large share of all federal taxes but not all. Hence, the issue seems to have narrowed to whether higher income households are the only ones who should pay more. It seems to me that tax fairness should not be confined to just between quintiles but also among quintiles. The overriding factor should be that if we want our government sponsoring more consumer expenditures, then we all should be prepared to pay more taxes. One can argue with the former, but not the latter. Importantly, the tax code should be used to generate the revenue necessary to pay for the government we have decided upon. There is no such thing as a free lunch, although we always seem to be looking for one.

My general principle to guide tax reform is that we try to simplify the tax code by making it a system to collect revenue rather than to redistribute income. In this regard, I would eliminate the payroll tax, enhance the individual income tax accordingly, reform the corporate income tax code to treat interest payments and dividends the same, and broaden the tax base by eliminating preferential tax treatment of certain outlays and sources of personal income. I believe that this would treat households in a particular income quintile more equitably than the current tax system. It may also allow taxpayers to make more of a connection between federal government outlays and the taxes they pay; that is, force fiscal policy makers to be more accountable. Of course, anything that might impose fiscal accountability will have little chance of being enacted.

Conclusion

Predicting what might happen in the short-term is very difficult because it will depend on what politicians do about the cliff. In that regard, I have no special insight. However, I would argue that even if politicians do nothing to avoid the cliff before the end of the year, it would not preclude them from doing something next year. It would be an administrative nightmare but not impossible. The more likely first step in the near-term would be to repeal any spending cuts and extend the current tax code for several months in return for a commitment to examine a major overhaul of the budget process. Whatever compromise is agreed to in the near-term, major tax-reform legislation most likely will be the longer-term goal, regardless of who is in the White House. And in either case, broadening the income tax base will be a key component of the reform proposal. I would prefer that this broadening of the base be accompanied by a simpler tax code, but that remains to be seen. The bottom line is that the federal tax system is already progressive, given that the average total federal tax rate increases with income. Nevertheless, several questions remain, including how progressive it should be, how fair the current system might be, and whether the system should be used to reallocate income?

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1. Earned income is subject to both income and payroll taxes, whereas other income is subject only to the income tax and frequently at a preferential rate relative to the tax rate on earned income. Under the health-reform legislation enacted in 2010, new Medicare - related taxes will be imposed on the unearned income of some high income individuals starting next year. This is way for the government to add progressivity to the funding of Medicare, but it complicates the tax code in doing so. A better way would be to fund Medicare with the individual income tax, which is already progressive and has a much broader tax base than current Medicare taxes.

2. Congressional Budget Office, An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022, “Economic Outlook,” August 22, 2012, pp. 31-33.

3. Federal tax liabilities are the amount of federal taxes a household owes based on income earned in a year, regardless of when the taxes are paid. In assessments of the impact of various taxes, individual income taxes are allocated directly to households paying those taxes. Social insurance, or payroll, taxes are allocated to households paying those taxes directly or paying them indirectly through their employers. Corporate income taxes are allocated to households according to their shares of capital and labor income. Excise taxes are allocated to households according to their consumption of the taxed good or service. Congressional Budget Office, The Distribution of Household Income and Federal Taxes, 2008 - 2009, July 2012.

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For the current economic forecast, as well as other analysis and commentary, please visit the Stonebridge Capital Advisors website.

Dlaufenberg@stonebridgecap.com

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


Current Perspective

2012 Economic Perspectives

Going over the "fiscal cliff" -- November 2, 2012

Factors that drive consumer spending -- August 13 , 2012

House prices: the bottoming process continues
--
March 8 , 2012

Equities and the political calendar
-- February 7, 2012

2011 Economic Perspectives

Is the great American job machine finally broken?
-- December 6, 2011

Recession fear, not fact
-- September 4, 2011

Core inflation: a policy guide more than a policy target
-- May, 2011

Help not wanted?
-- Feb, 2011

Special Report: Health Care Legislation:
Essay No.1 - Costs
Essay No.2 - Revenue
Essay No.3 - Budget Deficits

2010 Economic Perspectives

Causes of the financial crisis revisited
--November, 2010

A less robust U.S. Economy longer term
--August, 2010

Greece: A test of Europe's resolve to remain united
--May, 2010

The U.S. jobs machine restarting at a slower pace
--February, 2010

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