The US heads toward 2013 fearful of the fiscal cliff. President Obama and congressional Republican leaders are arguing over tax burdens on the well off and the correct balance between revenue increases and spending reductions. As the President’s economic advisors surely know, economic evidence points to fiscal consolidations being overwhelmingly about spending restraint, rather than revenue increases. But the battle at the cliff is political rather than economic and can best be analyzed as such. Next year will bring a forced discussion of political choices.

 

Three observations shape this intellectual meal in the new year.

 

First, the principal decision is about the size and scope of government. This is less about defining a percentage of gross domestic product government should account for than about what role government should play. We want to secure our defense and invest in physical and human capital. What, though, of the welfare state? If we seek social insurance for the least well off, the size of government relative to the economy need not change much from historical norms. If middle-class entitlements are our goal, the size of government will increase.

 

Second, a larger government will require higher taxes — on everyone. After a New Year’s Eve policy hangover, we will realize that a larger government cannot be paid for simply by ‘taxing the rich.’ All of the tax increases on upper-income households currently proposed may be as much as 1 per cent of GDP. While a significant sum, deficits in the near term –and, more important, in the long term — are an order of magnitude greater. If in 2013 the public accepts a vision of a large government, a tax system that can raise much more revenue from many more people will be needed. Industrial economies with much larger welfare states than the United States typically pay for that largesse with less progressive, broader-base tax systems.

 

Third, there is little chance of escaping a fiscal trap of high debt and crushing tax burdens without a resumption of more salutary economic growth. Faster growth raises living standards, of course, but also reduces debt burdens relative to the size of the economy, easing the pain of needed fiscal consolidation.

 

These observations point to two paths, one in policy, the other in process. 

 

First, a shift toward consumption taxation to reduce distorting corporate and individual income and payroll taxes can raise economic growth and more revenue. There have been many recent proposals from economists for progressive consumption taxes — some of which can be implemented with not too many changes from our present tax structure. Nor do we have to change all at once. Twenty years ago this month, then US Treasury Secretary Nicholas Brady outlined in a speech at Columbia Business School a plan to use a modest consumption tax to decrease the elements of the income tax most harmful to growth – particularly taxes on business income and payrolls. A shift toward consumption taxation is a pro-growth support for a smaller government; it would be all the more necessary for financing a larger one.

 

Second, the fiscal dysfunction that rings in the new year is less an economic problem (its solution for any likely desired size of government is not beyond our grasp), but a political one. Modern deficits and debt, in contrast to historical budget patterns, are less about debt build-ups in war and pay-downs in peace than about the unchecked rise of the welfare state. As a consequence, the new Congress will talk about process. One adaptation would be to place on the explicit budget increases in accrued liabilities of entitlement programs, with such increases requiring higher taxes or offsetting decreases in other spending. If the sirens’ song is still too tempting, a mast of a constitutional requirement for budget balance over a multi-year period must be considered.

 

These thoughts suggest clear tasks for President Obama and congressional Republican leaders. Given his vision of more generous social insurance and a larger government, the president needs to articulate a path of tax increases for all Americans – higher income taxes or a new consumption tax. While they have articulated the case for tax reform, GOP leaders must define more clearly the size and scope of government they seek. This definition should focus on a safety net version of Social Security and Medicare, with declining generosity for high-lifetime-income individuals.

 

So what will happen at midnight before the new year? U.S. leaders should agree on a 10-year deficit targets with revenue and spending components, but then quickly adopt a new year’s resolution of a real debate about the role of government and how it will be paid for. With the next election in 2014, 2013 will be the last opportunity for awhile for big change – watch closely.

 

This opinion piece by Glenn Hubbard appeared in The Financial Times on December 10, 2012. FT.com