Friday, December 28, 2012

The Fiscal UnCliff - A Guide For The Perplexed

Is the Fiscal Cliff a cliff or not a cliff, that is the question (wait . . . what is the question)?

1.  To understand a word that everyone is using to describe the budget battle you need to understand the Congressional Budget and Impoundment Act of 1974 which established the Congressional Budget Office (CBO) and set up the budgeting process used by Congress to this day.

The word is cut and Mr Inigo Montoya makes an insightful comment on its use:

Of particular import in the 1974 Act was the introduction of the concept of baseline budgeting.  In baseline budgeting you take the budget for baseline year 1 (X) and then, based upon expected inflation plus about 3%, you set the next year's (Year 2) baseline budget (X+Y%).  Any reduction from the projected Year 2 baseline budget is considered a cut even if the reduced budget is an increase in actual spending over Year 1.  When you hear the term cut in regards to the Federal budget it is usually not referring to reductions in actual spending but rather reductions in projected increased spending. Got that?

For example, over the past year there has been a lot of discussion over Congressman Ryan's proposed budget in the context of cuts.  In reality, the Ryan budget increases federal spending by 25% over the next decade compared to the Administration's 50% increase.  Neither budget actually cuts spending. 

For that matter, the 1974 budget process has broken down in recent years.  The House has passed budgets annually, but the last Senate budget was passed in April 2009 and since then the Senate Majority leader has refused to introduce annual budget resolutions so there has been no Federal budget in the traditional sense since then.  In 2011, Senator Conrad, the Democratic chair of the budget committee, announced his committee would start marking up a budget but Senator Reid dissuaded him from proceeding.

2.  With that we can now look at the impact on revenue and spending if we "fall off the cliff".

The table below is from the August 2012 CBO update.  It shows actual 2011 revenues and spending, 2012 projections based on several months data and 2013 and 2014 projections based upon existing law, including the Budget Control Act of 2011 under which the Bush-Obama tax cuts (I use this terminology instead of the usual "Bush tax cuts", since the Democratic controlled Congress voted in 2010 to extend the cuts for two years based upon President Obama's request) end on January 1, 2013 and spending sequestration occurs. Take a good look at it, particularly the 2012 and 2013 figures.
According to the CBO, if we fall off the "cliff" the deficit is reduced by $487 billion in 2013.  However, spending is reduced by only $9 billion (or 0.25%) while revenue increases by $478 billion (or 19.13%).  

Putting it another way, 98.2% of the deficit reduction comes from tax increases and 1.8% from spending cuts. 

Of the total deficit reduction, 62% comes from increases in the personal income tax ($302 billion).  Of the $302 billion in additional income tax revenue about 25% comes from the increase in the rates of the two highest brackets, while the other 75% is from the increase in the lower two brackets.1

So, from the government perspective, while there is an actual cut, it's hard to see a 0.25% revenue decrease as a "cliff" or even a "bump" - maybe more like a train running over a quarter left on the track.

3.  Now another issue arises when you hear about negotiations over deficit reductions which also originated in the 1974 Act - budget "scoring" by the CBO.  In the 1970s, the CBO made 5 year budget projections and for the past two decades has used 10 year projections.  The 10 year projections are also used to score legislative proposals such as the Affordable Care Act and the Ryan budget.

There are three huge problem with these projections:

First, they are subject to gaming and both parties are experts at this.  One technique is to front load tax increases and backload nominal savings to make a proposal look balanced.  You know you'll get the tax revenue and by the time you're out a few years no one will be able to figure out if you got the savings but you can tell the public today it's balanced according to CBO.

Second, the acts of one Congress cannot bind succeeding Congresses so they are free to change the law and spending controls agreed to by prior Congresses.  The Medicare "doc fix" is a great example of this inaction.  In 1997, Congress passed a measure to control the growth of physicians' reimbursements under Medicare.  However, each year Congress votes to put off the reduction.  Because the "doc fix" is in current law the reductions attributable to it are in the CBO budget projections even though the reductions never actually occur!

And finally, none of us have a freakin' clue what's gonna happen next year let alone 8 to 10 years from now so these projections are completely useless as detailed roadmaps for policy and budgets.

So the negotiations you hear about are about cuts that are increases and about events in the future about which no one has a clue and cannot control.

The CBO is actually a fairly professional organization and although it is mandated by law to follow this process it is aware of these problems and you can often find alternative baseline scenarios in its reports.  They are usually at the back of its reports and proceeded by an explanation along the following lines:

"We know you bozos well enough to know you have absolutely no intent of following the laws you've enacted and that you will act in completely irresponsible ways so we're going to provide an analysis of what we think is really going to happen."
You should look at these alternative scenarios - they're pretty damn scary.

So, as the argument swirl around us just remember that the "deciders" are following the principle enunciated by George Constanza:

1. There's been a lot of misinformation over the fiscal impact of reverting to the Clinton-era tax rates for the highest two brackets (the "millionaire and billionaires" making more than 200K or 250K) typified by the recent remarks of Dennis Van Roekel, president of the National Education Association:

"I brought the message that, number one, it's important that we let the Bush tax cuts disappear for the wealthiest 2%. As we're looking for a $1.2 trillion solution, $829 billion takes us a long way there." 

Mr Van Roekel compared a one year deficit ($1.2 trillion) with ten years of revenue ($829 billion) from the increased taxes.  In the real world, the increase would raise about $80 billion in first year revenues compared to the $1.2 trillion deficit.  However, given Mr Van Roekel's role in our educational system his mathematical confusion does raise a more profound issue: "is our children learning?"