Of Course the Sequester is Going to Happen

Despite the caterwauling on the horrible impact of sequestration that those wascally Wepublicans foisted on the poor President, it is going to happen.  A friend of mine saw Paul Ryan on Meet the Press towards the end of January and immediately concluded that the Republicans were not going to be blackmailed over defense cuts.  Ryan's performance is masterful and worth taking the time to watch, he schools David Gregory. Ralph Benko predicted that the Republicans want to actually have the fight over spending when the Continuing Resolution expires on March 27.  The Republicans will have the leverage that comes from the need to continue funding the government.  When the House puts forth a budget that keeps the government running, the Democrats will be hard pressed to allow the government to shut down.  This gives the Republicans the opportunity to more permanently reduce government spending by passing a budget for the rest of the fiscal year.

Meanwhile, I know from first hand knowledge that one of the reasons the sequestration is going to hit the Department of Defense particularly hard is that Obama directed the Department of Defense to spend at last year's level of funding through the first half of this fiscal year.  As a result, when a budget cut of 10% has to be executed over half the year, it looks like a more drastic 20% cut.  I suspect, but lack the proof, that the President did this for political reasons.  First, he did so not to lose votes in places like Virginia.  Second, he got the additional benefit of making the cuts to defense appear more draconian because they must be executed over a shorter time frame.

Meanwhile, most of the country is going to yawn at the actual effects of sequestration.  There will be pockets of pain in cities with a high concentration of defense civilians, and maybe some longer lines at the airport.  I think this works to the advantage of those who want to cut spending because the over-reaction to sequestration will be seen as "crying wolf."

Why Republicans Are Content to Sequester

It's the only way they can get Obama and the Democrats to cut spending.  I just assumed that the Republicans had given away the farm on the first sequestration deal, because my concentration has been elsewhere.  (The good looking Chief pictured in this post died last Friday, he was not my Dad, but certainly a father-figure in my life.)  An article by Ralph Benko in Forbes alerted me to the reality of the tax deal.

I reviewed a summary of tax law changes at Yahoo Finance.  The bad news is that the top rate increases from 35% to 39.6%, but that is not even that bad of news.  It affects married filers with income over $450,000, and frankly they will find ways to avoid that tax.  That group's capital gains rate will increase to 23.8% (20% + 3.8% for mediscarce).  Meanwhile, 99% of the Bush tax cuts are made permanent.  The payroll tax was restored to its historic rate of 6.2%, from the useless and temporary cut to 4.2%.  This will slow the hemorrhaging in the Social Security account and ensure that lower income Americans are also paying taxes.   Best of all, the indexing for alternative minimum tax was made permanent and little was changed in the gift and estate tax rules. Benko wrote that Boehner scored a huge victory, because the tax deal deprives Obama and the Democrats of the revenue to fund their agenda.

Enter sequestration.  Since the Democrats have expended their ammo by cutting the tax deal and "taxing the rich," there is little revenue for them to offer for deficit reduction.  The administration deliberately prevented the Defense Department from planning for sequestration at the start of this fiscal year, thinking the Republicans would blink.  They have not.  The cuts imposed are going to be very painful in the short term, but that's only because Obama's lack of leadership are forcing a 10% across the board cut to be executed in the second half of the fiscal year, making it look like a 20% cut, for the time being.  But some of the problems with military spending have little to do with readiness.  Retiree health care costs now consume 10% of the military budget, $59 billion, up from $20 billion only a decade ago.  Military pay raises have outpaced inflation over the same period.  In the decade ending in 2009, military pay had grown 52%, while civilian wage inflation over the same period was 38%.  The other big headache is that the military operation are heavy users of petroleum based fuels.  Operations and maintenance is the biggest defense budget category and the high price of fuel contributes.  In my opinion, reducing training tempo, deferring maintenance and releasing soldiers and sailors is where they will find the big money to pay for the cuts.

So the Republicans believe that they can live with defense cuts, while other programs favored by the Democrats also get axed.  Defense spending was overdue for a pullback, the country does so after every wartime period.

Of course, none of this deals with the real fiscal threats, social security, mediscarce and medicaid.  Looking at the graph below, if you count interest on the national debt as a transfer payment, then transfer payments, mostly from the young to the old, consume 60% of the federal budget:

If we don't get those under control, squabbling over the other 40% won't really make much of a difference.

The Wimpy Way to Deficit Reduction

"I'll gladly pay you Tuesday for a Hamburger today," Wimpy of Popeye fame is often quoted as saying. The implication of course, was that Wimpy was never going to come up with the cash on Tuesday. With the Gang of Twelve meeting the last two days, but apparently having no comment on their actual discussions, Rodger Hedgecock helpfully summarized things today. The Democrats will offer three dollars of future spending cuts for a dollar of tax increases today. The Republicans will be split between this "bipartisanship" approach and those who want to stand firm on any tax rises. It reminded me of Wimpy's proposition. Rodger reminded us that this is the standard Democratic trick, used against George H.W. Bush when he reneged on his "no new taxes" pledge. The spending cuts never come.

But why can't the Republicans reverse this game. We'll give you a dollar in tax rises tomorrow for three dollars of spending cuts today. Now Grover Norquist might start screaming that we shouldn't vote for any tax increases, ever. But he needs to understand my methods. First, as a matter of good politics, if we don't at least promise modest tax rises to pay for the coming spending cuts, then we will lose the political battle. The Economist makes this argument persuasively in this week's leader. Second, this presents an opportunity to reform the tax code. We should back load a phase out of all deductions and all of the other special goodies in the tax code. We should offset some of the increased revenue with lower marginal tax rates, which would be permanent. Third, if spending cuts and entitlement reforms produce the economic recovery that I expect, we can later vote for even lower marginal rates, in effect cancelling the tax hikes. Finally, we can argue that tax hikes now would harm the economy, so they have to be back loaded.

I have always believed that no tax hikes are needed to balance the budget. But sometimes the packaging is very important in selling the plan. Phasing out the deductions after giving people warning is a fair way to reform the tax code and reduce cronyism. Further, if we calculated decreases in the marginal rates that were exactly offset by the phase out of deductions in a static analysis, it would actually result in revenue growth for two reasons. First, the inefficiencies that are caused by hiding income would be wrung out of the system, resulting in greater growth than static analysis would predict. Second, because people would not have ingenious means of hiding income, but marginal rates were actually lower, reported income would rise.

The deficit commission can easily achieve the $1.2 trillion in cuts over ten years if such an approach were taken. The hard part would be to get the Democrats to go along, but I think the public would like it.