Posts Tagged ‘federal default’

Debt Ceiling-Deficit Reduction Talks

July 10, 2011

President Obama needs to start explaining to the American people what is at stake in the current negotiations between the Administration and the Congress on raising the debt ceiling.  Unless Congress raises the federal debt ceiling, the U.S. federal government will soon run out of money to pay its operating expenses and service its debt.  August 2 is the date, according to Treasury Secretary Timothy Geithner.  Republicans have been demanding drastic reductions in federal spending, with no increase in taxes of any kind, before they will approve an increase in the debt ceiling.

Last week, Congressional Republicans walked out of deficit reduction talks hosted by Vice President Biden.  Now President Obama has increased his participation by inviting Congressional leaders to discuss how to break the impasse.  During a Thursday meeting at the White House, the President proposed three options for reducing the deficit over a ten year period – a $2 trillion option, a $3 trillion option, and a $4 trillion option.  The Wall Street Journal gave a general idea of what was included in the $4 trillion option, but we do not have any specifics.  Initially, both President Obama and Speaker John Boehner were described as being in favor of a $4 trillion deal.  However, on Saturday night, Speaker Boehner issued a statement saying that he no longer favored a $4 trillion deal because that would have included “tax increases”, as Republicans call elimination of tax loopholes that favor the rich.

Recent polls indicate that a majority of Americans oppose raising the debt ceiling, but they also oppose any cuts to Social Security or Medicare.  In response to the intransigence of the Congressional Republicans, President Obama needs to explain to the American people that maintaining the full faith and credit of the U.S. government is paramount.  He needs to explain the impact that Republican demands will have on the lives of ordinary Americans. The President also needs to report to his own supporters what options he laid out for the Congressional leaders, and what the impact of those options would be.

The following four options are illustrative of what is at stake for positions of the Obama Administration, the Bowles-Simpson Deficit Reduction Commission, the Congressional Republicans, and the TEA party.  (Since we do not have the advantage of a large staff of economists like OMB or the Congressional Budget Office to score the options, I cannot give precise numbers for the size of the budget savings.)

Debt Ceiling/Deficit Reduction Options

Option I outlines the main features of a proposal that the President laid out in a speech on  April 13, 2011.  President Obama has emphasized some of the points in this list at various times during the first six months of 2011.

I. Increase Debt Ceiling, Invest in Infrastructure and Jobs

  • Must pay interest on debt.
  • Fund Infrastructure Investments
    • Roads, bridges, ports;
    • Maintain sewers and sewage treatment plants;
    • National electrical power grid.
  • Green energy technology development
  • Manufacturing innovation laboratories
  • Cap defense spending.
  • Implement the Affordable Care Act, including support for Medicaid.
  • Support states in school improvement projects.
  • Eliminate farm subsidies and ethanol production subsidies.
  • Eliminate tax breaks for oil companies.
  • Eliminate tax loopholes while cutting top corporate tax rate.
  • Let Bush-era tax cuts expire as scheduled.
  • Tax hedge fund manager fees as ordinary income.
  • Tax dividends as ordinary income.

II. Increase the Debt Ceiling, Gradually Reduce Spending, Increase Revenues

Option II outlines the main implications of adopting the recommendations of the President’s Deficit Commission, co-chaired by Erskine Bowles and Alan Simpson.[i] See

  • Pay interest on debt.
  • Gradually reduce defense and discretionary spending.
  • Maintain current levels of green energy development.
  • Maintain social security payments at current levels.
  • Maintain Medicare benefits at current levels, but aggressively seek ways to reduce health care cost increases.
  • Eliminate farm subsidies, ethanol subsidies, and tax breaks for oil companies.
  • Eliminate corporate tax loopholes while cutting top corporate tax rate.
  • Tax hedge fund manager fees as ordinary income.
  • Adopt the Bowles-Simpson Zero Plan to reduce the federal deficit to zero:
  1. Eliminate all tax expenditures—for both income and payroll taxes—except for the child credit, the earned income tax credit, foreign tax credits, and a few less common preferences.
  2. Eliminate the alternative minimum tax (AMT).
  3. Retain personal exemptions (no phase-out).
  4. Replace the current six-bracket individual tax rate schedule with a three-bracket schedule of 12, 20, and 27 %.
  5. Tax capital gains and dividends as ordinary income.
  6. Index tax parameters using the chained Consumer Price Index.
  7. Increase the Social Security wage base by 2 percent per year more than the growth in the average wage (making the FICA cap $140,100 in 2015).
  8. Phase in an increase in the federal excise tax on gasoline of 15 cents per gallon (13.5 cents per gallon on average in 2015).
  9. Eliminate corporate tax expenditures and reduce the corporate tax rate to 27 percent.

We do not have enough details from the Thursday White House meeting to know whether all of these Bowles-Simpson proposals were included in the options presented by President Obama.  The Wall Street Journal reported in a separate story[ii] that the President suggested the adoption of the chained Consumer Price Index as the basis for Social Security Cost of Living (COLA) adjustments and federal pension adjustments as well as for indexing tax parameters.  It is not clear why the President suggested this instead of raising the cap on salaries and wages subject to FICA.

Some economists favor the adoption of a chained Consumer Price Index because it takes into account changes in the quantities of goods and services that consumers buy as relative prices change.  For example, if the prices of French wines go up and the prices of smart phones go down, consumers may buy more smart phones but less French wine.  At present, some tax parameters are adjusted by the CPI-U, which does not take into account changes in quantity preferences as relative prices change.  Social Security benefits and federal pensions are adjusted using CPI-W, which is based on the increase in average wages.  However, over the past decade CPI-U and CPI-W have tracked very closely, whereas the chained CPI increased more slowly.

If someone were to retire now at age 62, the future benefits would be less using the chained CPI than using the current formula – 4% less at age 75, 6.5% less at age 85, and 9.2% at age 95.[iii]  The changes would be even worse for younger Americans.  If the chained CPI were really a better formula for showing the cost of living, there might be some justification for adopting it.  However, health care costs are rising faster than general living costs, and seniors are the largest consumers of health care.  None of the proposed CPI formulae take into account the higher costs that seniors incur for health care and long term care.

Increasing the FICA cap is a better way to ensure the solvency of the Social Security System.  There is no reason to stop at $140,000 annual salary.  If FICA applied to wages and salaries up to $200,000 annual income, the Social Security System could remain solvent for the rest of the century.

III. Raise the Debt Ceiling, Reduce Spending, Reduce Taxes on the Wealthy, Eliminate Social Security and Medicare

Option III reflects the mood of Congressional Republicans, including a lot of Republican proposals.   Republicans say repeatedly that the United States does not have a revenue problem, it has a spending problem, and many Republicans in Congress would vote for Option III.

  • Pay interest on debt.
  • Maintain defense budget.
  • Drastically reduce discretionary spending.
  • Eliminate Department of Education and drastically reduce Pell Grants (student aid for college education); states are responsible.
  • Eliminate spending on green energy development; private sector is responsible.
  • Eliminate food stamps and Women, Infants and Children programs.
  • Cut 50% of funding for the Securities and Exchange Commission and the Commodity Futures Trading Commission.
  • Cut 30% from funding for Food and Drug Administration (FDA).
  • Privatize social security for those under 55; individual’s accounts would be invested in the stock market.
  • Repeal the Affordable Care Act.
  • Privatize Medicare, but with a Federal voucher system; current retirees would keep their current benefits.
  • Make Bush-era tax cuts permanent.
  • No tax increases:  maintain farm subsidies, ethanol subsidies, and tax breaks for oil companies; hedge fund managers continue 15% tax on their fees; dividend rates are 0% or 15%.
  • Cut top corporate tax rate to 27%.
  • Eliminate the alternative minimum tax.

IV. No Increase in the Debt Ceiling

The U.S. government reached its statutory debt limit on May 16, 2011.  The Treasury has been using “extraordinary measures” that will allow the government to extend its borrowing authority until August 2.  There is a large amount of debt coming due on August 4, and there will be no way to roll over the debt or pay the interest due unless the debt limit is increased.  Standard & Poors has stated that any U.S. Treasury bond that has a payment due on August 4, 2011 will be downgraded from AAA to D if Congress does not increase the debt limit.  The results of such a debt default would be catastrophic, and many Congressional leaders have stated that it will not happen.

Option IV assumes that Congress fails to come to a long-term deficit reduction deal but enacts a temporary and small increase in the debt ceiling on August 2, 2011.  Clearly, Option IV is not a long-term solution to the problem of balancing the budget, but it would cause so much economic pain that it would quickly get the attention of an apathetic public.

  • Government is allowed to spend only its current revenues.
  • Must pay interest on the debt as well as fund current operations.
  • Drastic reductions in government expenditures until debt ceiling increased
    • Government salaries are cut 50%.
    • Social Security payments are cut 50%.
    • Government retirement pensions are cut 50%.
    • No Medicare payments until debt ceiling is increased
    • All National Parks are closed.
    • FEMA suspends operations.  Reponses to natural disasters, such as hurricanes, earthquakes, floods, fires, and tornadoes, will be the responsibility of the states.
    • Staff positions at foreign embassies are cut 50%.
    • All consular offices are closed.
    • U.S. Passport Office is closed until debt ceiling is increased.
    • Subsidies to the U.S. Postal Service are eliminated.
  • Start to sell stored commodities such as gold in Fort Knox and oil in the Strategic Petroleum Reserve.

It should be clear that Option IV would create quite a stir, and if implemented for very long would result to riots in the streets just like in Athens. People need to see where the TEA party recommendations would lead.  It is unlikely that Republicans in Congress could “hang tough” in the face of the public outcry if Option IV were forced on the President.

We should add what the consequences of Option III would be. If the Republican agenda were adopted quickly, if Option III were implemented within a year, it would lead to a new recession.  IMF studies show that a budget cut of 1% of GDP typically reduces demand by about 1%, and increases the unemployment rate by 0.3%.[iv]

Since the Federal Budget Deficit is about 10% of GDP, an immediate or short-term cut in Federal spending to try to balance the budget with no revenue enhancements (as the Republicans demand) would result in a reduction of 10% in domestic demand and a rise in the unemployment rate of 3% to 12.2% This would be worse than the recent recession that officially ended in 2009. The Federal Budget would not in fact be balanced because ensuing recession would result in lower tax revenues.

President Obama should not cave in to Republican demands.  He should explain in a lengthy televised address to the American people what the three options are that he suggested to the Congressional leadership, and what the consequences would be if the Republicans were to force a solution like Option III above.  Then he should make it clear that unless the Republicans compromise, the outcome will be Option IV, which will be a disaster.

[ii] “How Tweaking Benefits Would Work,” Wall Street Journal, July 8, 2011, p. A4.

[iv] World Economic Outlook, October 2010, Chapter 3, “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation,” p.113.