A Lesson in Economics for the National Deficit Commission

The French statesman Georges Clemenceau famously called war "too serious a matter to entrust to military men;" and in the same spirit, national budgets in a democracy are too important to leave to economists.  But no sensible government would wage war without listening to general and admirals, and the National Commission on Fiscal Responsibility and Reform - aka the National Deficit Commission -- would be equally well served to consider basic economics more carefully.  This week's leaks from the Commission include reports that its members are leaning towards cutting back the deductions for mortgage interest and employer health insurance payments.  This approach could certainly raise a lot of money in the short-run.  But for an economy suffering as ours is from weak demand, a fragile housing market, and a decade of slow hiring and income gains, these proposals are economically illiterate.

Listen up, members of the National Deficit Commission.  This is the wrong time - maybe the worst time - to target the mortgage deduction.  Falling housing values have been the single largest force holding down consumer demand, and with it investment and growth, because their decline leaves the 70 percent of Americans who own their homes poorer.  That has created a classical, negative wealth effect which dampens spending.  And on top of that, these falling housing values sharply raise the ratio of most people's debts to their assets, moving most people to reduce their debt.  And that has meant fewer large purchases and less credit-card buying.

Cutting the mortgage interest deduction would only intensify these dynamics, because the value of that deduction is incorporated or "capitalized" in housing prices.  When prospective home buyers try to figure out whether they can afford the monthly payments on a particular house, they naturally factor in the value of the deduction.  Buyers are willing to pay more than they would without the deduction - and sellers demand more than they could without it.  Reduce the deduction, and buyers will be able to afford less, sellers will have to accept less, and housing values will fall further.

There are reasonable arguments for paring back this deduction, since it channels so much investment into housing.  Of course, that's its explicit intention, so home ownership can be part of the American dream.  And yes, a smaller deduction would raise considerable revenues.  But doing it would inescapably further drive down housing values, and doing it now could lock in years more of slow economic growth.

This is an equally ill-timed moment to cut back the deduction for employer-provided healthcare insurance.  Once again, there are reasonable arguments for rethinking this deduction, but shrinking the deficit under current conditions isn't one of them.  Limit this deduction for employers, and hiring costs will go up at a time when job creation is already historically weak.  Worse, the change would raise the cost of retaining people working today, creating new pressures for more layoffs.  The Commission may be talking about taxing workers, not businesses, on some share of the value of their employer-provided health insurance.  That seems no more sensible economically at this time, since it would reduce most people's after-tax incomes at a time when their consumer spending is historically weak. 

The truth is, this is not the time for any short-term deficit reduction.  We tried fiscal tightening in 1937, at the early signs of recovery from the Great Depression, and it bought us four more years of slow or negative growth.  Japan tried it too in the mid-1990s, during the early stages of their recovery from a financial meltdown, and it set off another half-decade of economic stagnation.  Now Britain's new conservative-coalition government is trying budget austerity, and the results almost certainly will be similar. 

Yet, it also would be foolish for the Commission to squander this rare public support for deficit reduction, so long as its members focus on the long-term and consider the economic fallout from their various brainstorms.  The place to begin is with the two forces driving the long-term deficits - prospective, fast-rising entitlement spending, and taxes that raise sufficient revenues only when the economy booms.  On the spending side, Social Security could be the relatively easy part, because its budget gap remains comparatively small for many years - if Americans are prepared to accept smaller benefits down the line.  Experts figure, for example, that we could close one-third of that gap by using the CPI for the elderly, rather than the higher overall CPI, to calculate future cost-of-living adjustments.  And much of the rest of the problem would fade away if we tied the annual increase in people's initial benefit to a combination of wage gains and inflation, rather than just wage gains.   

The harder part involves Medicare and Medicaid costs.  As with Social Security, the main difficulty lies not in figuring out how one could slow annual cost increases in health care, but rather in marshalling majority support for such measures.  In fact, the President's health care reform already included a catalogue of approaches to slow the growth of medical costs, albeit on a limited scale or in weak form.  The Commission could urge Congress to scale up and strengthen those measures.  If those reforms work, they not only would generate large budget savings down the line.  The same approaches also would support jobs and incomes, since fast-rising health care costs have significantly slowed job creation and wage progress.

The Commission purportedly has agreed to use additional revenues to close one-third of the long-term deficit.  Assuming that additional taxes would go into effect only once the economy fully recovers, higher taxes for wealthy Americans would raise revenues without severely damaging demand, since they don't spend nearly all that they earn.  The same idea could even be applied to industries which, by economy-wide standards, earn abnormally high profits.  By this measure, the leading candidate is finance.  A small tax on financial transactions, for example, would raise substantial revenues for the deficit with little adverse effect on the overall economy if other advanced countries follow suit - and Germany, France and the United Kingdom all have indicated interest.

And if the Commission wants to tackle broader tax reform, the top candidate should be a carbon-based fee on energy.  A tax on greenhouse gas emissions not only would restore U.S. leadership on climate change.  It also could turbo-charge the development and deployment of green fuels and technologies, a potential source of exports, and reduce our dependence on foreign oil and the consequent distortions in our foreign policy.  And if Congress set a carbon tax high enough to sharply reduce CO2 emissions, good a share of the revenues could go to reduce payroll taxes, spurring job creation and income gains. 

These approaches may not satisfy the balance-the-budget-at-all-costs crowd.  But sound deficit reduction requires a larger economic frame.  At a time of serious economic stress and frustration, the National Deficit Commission should embrace real economic thinking.