Will Washington's Budget Standoff End With a Tax Increase?

The U.S. faces a record $1.5 trillion budget deficit for 2011, and this week, there's a chance that House Republicans will shut down the government in an attempt to use the pain that would cause to achieve their political objectives.

On a deeper level, Republicans want to do everything in their power to make sure Barack Obama is a one-term president. In that mission, anything they can do to slow down economic growth will help their cause, because -- according to the uncannily accurate predictions of Yale economics professor Ray Fair -- if U.S. GDP grows at 3.7% in 2012, Obama will win nearly 56% of the popular vote.

But if anyone in Washington was serious about reducing the budget deficit, they'd follow the script laid out by Bill Clinton after he faced down the Republicans in 1995 and early 1996. In that scenario, the federal government would raise taxes to balance the budget. After all, Clinton was the only president in recent memory who really got the economy performing at its peak: He left office after having presided over the creation of 22.2 million jobs and a $211 billion budget surplus.

Clinton was fortunate that the Internet took off while he was in office. But Treasury Secretary Robert Rubin also pushed a policy of balancing the budget as a way to tamp down inflationary expectations so investors would feel confident. That confidence created a climate of low interest rates and a boom in venture capital and initial public offerings that fueled many of the startups that helped create all those jobs.

Do Republicans Want Higher Taxes or a Higher National Debt?

In some ways, we're back where we were in 1995, but the game today is different. Republicans, following the leadership of Rep. Paul Ryan (R-Wisc.), is proposing to privatize Medicare and Medicaid, the government health plans for the elderly and the poor, among other changes. But according to The Wall Street Journal, Budget Committee Chairman Ryan's proposal is vague on paying down the debt, and it can only balance the budget if taxes rise. The Journal cites three reasons:

• It delays balancing the budget, requiring higher debt ceilings. Since Ryan's proposal doesn't balance the budget until about 2030, the only way for the government to keep operating without tax increases would be to raise the debt ceiling every year until 2030.

• It delays Medicare cuts, thus doing nothing to lower deficit for decades. Ryan's "most far-reaching change" cuts government spending for Medicare beneficiaries' health care. But current retirees would remain under the current plan which means that Ryan's proposal won't save the government money for decades.

• Despite a lack of detail in Ryan's plan, the cuts that would make a difference are too severe. To make a serious dent in the deficit would require draconian budget cuts, and the political will for such cuts appears scarce.

The reality is that Congress must choose at least one of two options: raising taxes or lifting the national debt ceiling. From a political standpoint, this choice nicely cleaves the factions of the Republican party. The small-government wing of the GOP supports Ryan's combination of tax cuts and budget cuts, while the anti-national debt, end-the-fed wing passionately opposes raising the national debt.

If sufficient political will existed to make the choices required to balance the budget, there are plenty of ways to increase tax revenues and reduce spending. For example, companies paid far less than the average 35% corporate tax rate on their $1.68 trillion in 2010 profits: Just closing all the loopholes that allowed GE to pay no taxes on its $5.1 billion in U.S. profits would reduce the deficit by as much as $600 billion (based on the reasonable assumption that other U.S. companies are using similar methods to avoid paying taxes). If you then raised taxes on families earning more than $250,000 from 35% up to the 39.6% rate where they were during the booming Clinton years, and got the U.S. out of its wars, you could make a real dent in that deficit.

Clinton Proved That Deficits Matter

There's a long history of division in Washington over the significance of deficits. In 2002, then-Vice President Dick Cheney famously told then-Treasury Secretary Paul O'Neill, "Ronald Reagan proved that deficits don't matter." But Cheney was simply rebutting the George H.W. Bush wing of the Republican party: The senior Bush famously pointed out during his 1980 primary debate with Reagan that cutting taxes while increasing defense spending and expecting to achieve a balanced budget was "voodoo economics."

The first President Bush helped set the U.S. on a path to economic strength by raising taxes. Back in 1990, he wanted to boost the economy but Fed Chair Alan Greenspan said he would only lower interest rates if Bush cut the deficit. So Bush back-tracked on his "read my lips, no new taxes" pledge, and in August 1990 submitted a budget that satisfied Greenspan.

According to the Fiscal Times, Bush's final deal "cut spending by $324 billion over five years and raised revenues by $159 billion." Congressional Republicans were outraged by Bush's decision to raise the top income tax rate from 28% to 31%.
But Bush's sense of fiscal responsibility helped set the stage for Bill Clinton, who exploited the resulting economic strength to preside over the best economy in recent memory.

If the interests of the middle class were being considered in this debate, the focus would be on creating jobs rather than cutting taxes for corporations and the wealthy while asking the middle class to pay more for essential services. And unlike 21 years ago, high interest rates are not impeding economic growth. This time, the budget standoff is a sideshow being trumped up for political purposes.

From the perspective of the average American, what matters is whether the budget impasse can be resolved without interrupting the trajectory of rising economic growth. If that happens, Obama will ride the wave of recovery to reelection.