I have fond memories of summer trips to Perkins Cove in Ogunquit, Maine – for lobster yes but also for the scenery along Marginal Way, a narrow path along a cliff by the beach. Getting down to the pleasant waters requires navigating a narrow path down the rocks.

And so it is, figuratively speaking, with tax policy and the fiscal cliff. A sensible approach can lead us to the water: less uncertainty and stronger growth. But we must first define the path, then find the way down.

 

US policy makers must begin by realising three points. First, raising revenue is about raising average tax rates, not marginal tax rates, as Barack Obama’s campaign suggested. Higher marginal tax rates distort behaviour and reduce activity. There are ways to raise revenue without increasing marginal rates. Tax deductions should be scaled back, especially in the areas of mortgage interest, charitable giving and employer-provided health insurance.

 

Second, tax increases should form only a modest part of the approach to deficit reduction, given the urgent need to curb spending by the federal government. Since the financial crisis, federal spending as a share of gross domestic product has been elevated by as much as 4 percentage points relative to its long-term average. The Congressional Budget Office long-term forecasts suggest this elevation will persist. Indeed, the CBO forecasts that spending on social security and Medicare could rise by 10 per cent of GDP over the next 25 years.

 

Third, fiscal consolidations are less detrimental to growth when they are overwhelmingly about tax reform and spending reductions, particularly cuts in transfer payments, according to academic research by Alberto Alesina and Silvia Ardagna.

 

So given these three points, what should those negotiating the fiscal cliff do? The first step is to raise average (not marginal) tax rates on upper-income taxpayers. Revenue increases should first come from these individuals. This means closing loopholes. For instance, the Bowles-Simpson commission, which Mr Obama established, has proposed limiting tax preference benefits for upper-income households. Also, Martin Feldstein of Harvard University and Maya MacGuineas of the Committee for a Responsible Federal Budget have suggested caps on the amount of deductions relative to a taxpayer’s income. These ideas are good places to begin.

 

The second step would be to agree to a package of expenditure reductions to occur over the next 10 years. These would include decreases in the growth of defence and non-defence discretionary spending. Gradual increases in the retirement age for social security benefits will also be important.

 

The third step is both fundamental and difficult: it is to realise that a strategy of “taxing the rich” cannot pay for the entitlement state. If we wanted a larger government as a share of GDP, we would have to raise taxes substantially on everyone.

 

The present tax system can raise at most about 20 per cent of GDP in a booming economy. A government of, say, 25 per cent of GDP cannot be paid for by changing rates in such a system. The distortions would be too great. Rather, as in most other advanced economies, a universal consumption tax would be required. (Such a tax would also enable reductions in individual and corporate income tax rates.) An alternative route – superior from the perspective of growth – would be to reduce benefit expenditure over time for the non-poor. This would allow for both a lower tax burden and for investments in education, research and development, and infrastructure. These are political choices and it is important that our leaders be candid. Mr Obama cannot argue that we can right the fiscal ship simply by taxing the rich. Republicans cannot argue for low tax rates without being clear about where cuts must come from.

 

These steps are not dependent on a “grand bargain” by the lame duck Congress or on sweeping reform in early 2013. But they do represent a map for how the US can once again begin to find its fiscal way.

 

This op-ed appeared in The Financial Times on November 12, 2012.