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Fiscal Cliff Calamity

Irwin M. Stelzer

Let’s be clear what the bargaining over the fiscal cliff is all about. It is not about a long-term solution to our run away deficits and the iceberg looming in the distance: entitlement spending that will sink our fiscal ship. It is not about extracting more revenues from “the rich,” however defined. It is about how to avoid triggering a combination of tax increases and spending cuts that just might tip our still-fragile economy into recession. It is about how, not whether, to increase taxes on higher earners who everyone agrees will end up paying more, perhaps because they should, perhaps because that is what the election results dictate, perhaps because … pick your own reason.

Republicans have indicated a willingness bordering on eagerness to eliminate many of the special tax privileges of upper income people. (Lobbyists for these groups have yet to be heard from, however, and have a special place in the hearts of the Republican establishment.) Even House Republicans, or at least the sane members, are willing to limit deductions, end special treatment of hedge fund operators’ income and dividend income, reduce deductions for interest on large and on second-home mortgages. All these changes would not only add revenue for the Treasury, but increase the efficiency of the economy, most especially by ending the diversion of capital into the housing sector, and talent into financial services. That is a long-term Republican goal.

All of these changes would hit upper income taxpayers especially hard, with collateral damage to the housing sector, charities, dividend paying stocks, hedge fund operators and those who live on capital gains. But they would not interfere with incentives to work hard and take risks (although some argue that small business start-ups would suffer because entrepreneurs start these firms with the hope of selling them, the proceeds to be taxed as capital gains, while other point out that despite favorable treatment of these gains new business formation is at its lowest level in over 30 years).

The president has a different view. He is not in the efficiency business; he is in the class warfare business. He seems not to worry about reducing incentives to take risks and to work hard. So he wants to get more from the rich by raising the top marginal income rate to pre-Bush tax cut levels, regardless of the effect on total revenue going to the Treasury. Obama probably knows that Romney adviser Glenn Hubbard is right to say, “Higher marginal tax rates distort behavior and reduce activity.” But that has nothing to do with his policy goal, which at least in the short-term, and most probably in the longer run, is a fairer rather than a more efficient tax structure. A dollar of added revenue that improves the efficiency of the economy is of less interest to him than a dollar of new revenue that makes the rich understand that he means to take from them to support his programs, and the Republicans understand that “I won.” It might be argued that by getting what he wants he will remove some of the objections to the way market capitalism distributes income, but that is surely not his goal.

Which is why all of the talk about bipartisan agreement on how to avoid the fiscal cliff is just that, talk—unless Republicans are willing to fall on their swords, and accept humiliation and repudiation of their long-held view that the tax code is about incentives, not redistribution for its own sake. Some think it is in conservatives’ interests to do just that, and get on to the larger battles over health care, immigration, national defense, and entitlements. Especially since the president can have his way by allowing a tumble over the cliff, followed by a “tax cut” for those earning less than $200,000. He holds all the cards, Republican control of the House notwithstanding. If Republicans don’t play their very weak hand very well, Obama will end up with the short-term tax fix he wants, and still another political stick with which to beat the Republicans.

There is something gallant about Republicans who believe they really know the economic impact of a few percentage points increase in marginal rates, and are willing to go down fighting to prevent such an increase. But there is something reckless about becoming tax-fight kamikazes when there is an opportunity to live to fight another day. If the Republicans forego this short-term battle over the fiscal cliff, in which they will be seen as forcing the middle class to forego the benefits of the Bush tax cuts, even temporarily, and instead become the party that wants to reform the tax code so as to eliminate special favors that benefit the rich, they just might be able to ride the wave for long-run tax reform that seems to be gathering strength on both the right and the left.

Whether they will also be able to obtain reductions in the entitlements that have us on a path to penury is another matter. Liberal advocacy groups are gathering their forces for a fight to preserve those unaffordable benefits and even add a few billion here and there, and they will have the president and the left of his party on their side. But even if the liberals prevail on entitlements, if Republicans can cobble together a coalition for tax reform, we would end up with a tax code more rather than less likely to be consistent with stepped-up economic growth. Then, we could wait for the markets to force us to mend our profligate ways, cf. eurozone—perhaps in 2014, perhaps in 2016.

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