[First posted at Forbes.]
The fiscal cliff will not be a new topic to regular readers of this column. I have been writing about it for almost two years, including with publication of my short book in the Encounter Broadside series, Obama and the Crash of 2013.
What is new is the recognition that only free market Republicans can save our economy from hurtling downward off that cliff, if they get aggressive now about promoting their correct economic principles to the public, and transform crisis into opportunity.
If they would at least aggressively explain their policies to the public, even if Obama resists and pushes the economy off the cliff for now, they can gain working veto proof majorities in the midterms to rescue the American Dream before it is too late.
The foundation of the fiscal cliff is the increase in the top tax rates of virtually every major federal tax already scheduled in current law to become effective on January 1. That is when the tax increases of Obamacare become effective, and when the Bush tax cuts expire, which President Obama refuses to renew for the nation’s job creators, investors, and successful small businesses. Add in the explosive new regulatory burdens President Obama has scheduled for his second term, and the seeds for renewed inflation and recession the Fed has already planted, and we have in Obamanomics the perfect prescription for renewed recession next year, as I discussed in this column just two weeks ago.
The Washington Establishment is confusing the issue with their outdated, discredited, Keynesian economics holding that the sequestration spending cuts also going into effect next year as part of the 2011 debt limit deal are contractionary as well. But government spending per se does not promote economic growth and prosperity. Double entry bookkeeping reveals that such spending must be financed in some way. Whether that financing comes through higher taxes, higher federal borrowing, or the Fed printing dollars and causing inflation, it all involves a drain in some way of resources that would be more efficiently and productively used in the private sector, guided by market incentives and competition.
Plus there is a further drag on the economy depending on which of the financing means are used. Higher tax rates involve counterproductive disincentives for production, borrowing implies future tax increases and interest costs, and inflation further discourages saving, investment, and production. Higher government spending is consequently a drag on the economy, and cutting that spending is a boost to growth and prosperity.
Thus we are entertained by the spectacle of our national leaders and pundits telling us both that we must reduce deficits and balance the budget, but that such deficits are essential to economic recovery and growth, and the spending cuts necessary for such balance are at the same time contractionary. That reflects the fundamental confusion of Keynesian economics, holding that the foundation of economic growth and prosperity is adequate demand for goods and services, rather than increased production of goods and services. That is based on Tinker Bell economics that we can just spend our way to riches and prosperity, rather then recognition of the reality that we can only consume what we produce.
Demand in a free market economy can never be inadequate for economic growth and prosperity. If demand for a particular good or service is inadequate, then the price of that good or service will fall until demand equals supply. Keynesian prescriptions of higher taxes, deficits, or inflation to finance higher spending are consequently always themselves contractionary, and so never work.
Compounding the fiscal cliff threatening renewed recession in the short term is the even bigger issue of the long term fiscal and sovereign debt crisis, threatening long term stagnation and decline. CBO projects that on our current course, under current policies, federal debt held by the public would rocket to 140% of GDP by 2030, 220% by 2040, and 320% by 2050, on its way to over 700% by 2080. But the markets stopped lending to Greece soon after its national debt climbed over 100% of GDP, creating the country’s sovereign debt crisis.
This is the real reason we must balance the budget, and bring down federal debt as a percent of GDP. But history shows that the biggest influence on federal deficits and debt is not taxes or even spending but economic growth. When President George H.W. Bush agreed to raise taxes as part of the 1990 budget deal, the higher taxes pushed the economy into recession, and the federal deficit increased from $221 billion in 1990, to $269 billion in 1991, to $290 billion in 1992, when voters booted him out for violating the no new taxes pledge that got him elected.
President Obama and America will suffer the same result if Obama has his way and increases tax rates for virtually every major federal tax on January 1. The tax rate increases will cause renewed recession, and result in less rather than more federal revenues.
The traditional Washington establishment approach to balancing the budget is to negotiate an agreement on a package of spending cuts and tax increases, which is what President Obama thinks he is doing now. But that approach never works, and has no prayer of ever working.
That is because the tax increases are permanently adopted into law. But the spending cuts are never fully adopted, or if they are they are soon swept away in the next liberal budget. The federal experience with that goes back at least to 1982, when Congressional Democrats promised President Reagan $3 in spending cuts for every dollar in tax increases. Reagan went to his grave still waiting for those spending cuts. It didn’t work for his successor either, as recounted above. In 1993, President Clinton tried again with a Democrat Congress voting through a tax increase as part of another budget deal. By 1995, the new Republican Congress, elected to replace the tax increasing Democrat Congress, was greeted with a Clinton budget projecting continued $200 billion deficits indefinitely into the future.
The only way to balance the budget is with tax rate cuts, promoting booming economic growth, and restrained spending growth, enabling surging revenues from the growth to zoom past the spending. That is what former House Speaker Newt Gingrich and President Clinton did in the 1990s, cutting capital gains tax rates by nearly 30%, while restraining spending to produce record surpluses for four years.
This history reflects the more basic budget math that eludes most static thinking commentators, especially the pie chart lady Ruth Marcus at theWashington Post. (Pie charts of the budget reflect the most static thinking). Policymakers always budget to spend the tax revenues they think their tax policies will raise. But their static analysis never accounts for the negative incentive effects of the tax increases, and the resulting drag on the economy. So less revenues are produced by the tax increases than they expect, and have budgeted for, and the deficit reappears. In contrast, the revenues resulting from tax cuts are always underestimated by the establishment’s static analysis. But the budget is set to spend the revenues expected. When more revenues result, the consequence is budget surpluses. Besides the federal history recounted above, the same experience is shown repeatedly at the state level.
For all of these reasons, Republicans should hold fast to their position that additional, new revenues can and should be obtained only through the economic growth, and closed loopholes, resulting from tax reform, with pro-growth tax rate reductions rather than counterproductive rate increases. Countering all the phony, posturing, election season claims about their tax reform plans not adding up, Congressional Republicans should move quickly to draft, introduce and score their tax reform plans. The House Republican majority should require dynamic scoring for those reforms. They should demonstrate the workability and public appeal of these reforms, rather than sinking in the swamp of phony claims arising from bad faith negotiations.
That tax reform should begin with Rep. Paul Ryan’s proposed individual tax reform including a 10% rate for families earning less than $100,000 a year, and 25% for those earning more. Corporate tax reform should be based at most on a global average 25% corporate rate, with revenue neutral loophole closing, also scored dynamically. That should include territoriality, and tax amnesty for repatriation of the trillions of legally offshore corporate funds.
As explained above, necessary spending cuts are not contractionary as under Keynesian mythology, but expansionary, reducing the drain of resources from the private sector, and the future tax increases implied by world record shattering deficits and national debt. But the arbitrary sequestration threatening in particular our national defenses is not the best means of such spending restraint.
Spending cuts should be based on the results of intensive, House oversight hearings, and past OMB and GAO evaluations, with ineffective or counterproductive programs slashed or abolished or consolidated with other, continuing programs. The Department of Education can be sent back to the states with continued federal education assistance provided through block grants, consistent with the primary state role in education. The Department of Energy can be consolidated with the Defense Department
Entitlement reforms should be based on extending the enormously successful, bipartisan, 1996 AFDC block grant reforms to all federal, means tested, welfare programs, including Medicaid and food stamps. Given the past bipartisan success of such reform, and the resulting gains for the poor, public support for such reform can lead to its enactment this term. Model bills can also be introduced for Social Security and Medicare reforms to demonstrate the workability and appeal of those as well, though those cannot be enacted soon. That is necessary to set the groundwork for upcoming elections.
Reversing the fiscal cliff also requires reversing Obama’s exploding regulatory burdens, in particular the restrictions on increasing production of proven energy sources. That includes reversing Obama’s global warming fantasies, which are based on daydreams of expanded government power, rather than on real climate science. Abundant supplies of low cost energy rather than restricted supplies of high cost energy would replace another, effective, crippling tax increase with an effective pro-growth tax cut. The economy, particularly manufacturing, is especially sensitive to energy prices. The House should pass the REINS Act requiring Congressional approval for all major regulations, and other bills reversing regulatory excesses, again to frame the issues for 2014 and 2016.
The final ingredient for a long overdue, economic recovery boom is replacing the Fed’s arbitrary, discretionary monetary policies with a mandatory price rule, guiding monetary policy based on market prices for gold, silver, oil and other precious commodities.
If President Obama does turn out to be as ideologically rigid as many believe him to be, these necessary policies can be adopted by bipartisan, veto proof, Congressional majorities after the next mid-terms.