Balancing on the Cliff

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Hamilton Place Strategies | 1

December 5, 2012

Balancing on the Cliff:Why Entitlement Reform is Essentialto Balance and Can Even Make Room

for a Deal

Balance is in the eye of the beholder. In the case of the fiscal cliff, thePresident has focused his argument for balance on the need for higher

taxes on the wealthy in addition to spending cuts. But it is equally truethat no deal will be balanced if entitlement reform is not a part of it.

Without entitlement reform,no deal will be balanced in

the long-run and the U.S. willcareen from one GrandBargain to another over aperiod of years.

For Republicans, this meansnegotiating from a higher taxbase the next time we needa Grand Bargain. Essentially,if Republicans give in on tax rates without entitlement cuts today, theywill cede a larger government without really solving fundamental long-

term problems.

Rather than complicating negotiations, acknowledging the centrality ofentitlement reform for balance can open up potential compromises

that fall along current messages from both parties. Additionally,compromise on long-run issues could create the necessary politicalspace to maintain or even increase short-term stimulus measures toaddress our current economic difficulties.

Matt McDonaldRuss Grote

Hamilton Place Strategies805 15th St NW, Suite 700

Washington, DC 20005(202) 822-1205

Without entitlement

reform, no deal will be

balanced in the long-runand the U.S. will careen

from one Grand Bargainto another over a period of

years.!


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The Uneven Trade of Real Tax Hike for Nominal Spending Cuts

The problem with a deal comprised of tax rate increases and spending cuts withoutany entitlement reform is that the tax increases would be real, while the spendingcuts would be nominal. So while the tax increases will grow with the economy, the

spending cuts would remain constant, making any deal appear balanced in theshort-run, but weighted heavily towards tax increases over time.

To illustrate this concept, lets look at a hypothetical deal consisting of a 1:1 ratio oftax increases to spending cuts totaling $2 trillion over ten years and then extendedinto the following decade. In the first ten years, this approach may fit the balance

test. However, as the economy continues to grow, the same tax policy changes thatraised $1 trillion in revenue in the first ten years will raise significantly more in theout years. Meanwhile, nominal spending cuts will stay constant. In this static analysis,a 1:1 ratio of tax hikes to spending cuts nears 2:1 in the next ten-year window(Exhibit 1).1

Grand Bargain or Slippery Slope

This longer-term perspective also illustrates the other challenge facing our currentfederal finances. Outside the ten-year window, entitlement spending explodes.

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!1 By 2032, annual revenue increases from the CBOs Alternative Fiscal Scenario total $185 billion, compared

to just $100 billion in spending cuts ($1 trillion applied evenly over ten-year period).

Hamilton Place Strategies 1|

EXHIBIT 1

Over Time, Tax Hikes Will Grow Larger Than Nominal Spending

Cuts!

Source: HPSInsight, Based on CBOs Alternative Fiscal Scenario plus 0.5% of GDP in tax hikes ($1 trillion over ten years) and

annual spending cuts of $100 billion ($1 trillion over ten years)!

0

50

100

150

200

250

300

350

2013

2014

2015

2016

2017

2018

2019

2020

2021

Dollars($B)

2031

2030

2029

2022

2024

2032

2028

2025

2023

2026

2027

Spending Cut! Tax Hike!A 1:1 10-Year Deal Applied Over 20 Years !

An initial 1:1 deal that pairs tax increases and

nominal cuts becomes skewed towards tax

revenue over the longer run.!300!350!

250!200!150!100!50!0!


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While taxes on the rich may be enough to alleviate our fiscal imbalances in a ten-year window, they do not solve the main driver of government spending and ourfiscal imbalances in the long-run. Under virtually any deal that provides nominalspending cuts rather than curbing the growth of entitlement spending, anotherGrand Bargain will be necessary to actually solve our fiscal problems (Exhibit 2).

This is the fundamental Republican fear and the real issue holding back a deal. Whatwill happen when we have to solve this problem again (Exhibit 3)? Will we cutspending drastically on seniors (without any time for more gradual approaches) orwill a more balanced approach again be pushed?

Under our hypothetical 1:1 deal, by 2032 the remaining fiscal gap, not countinginterest payments, is just above six percent of GDP. Another 1:1 balancedapproach would raise taxes by an additional three percent of GDP. This increasewould bring taxes to 22 percent of GDP, just under the Progressive CaucusBudgets long-term target and a full one percent above Bowles-Simpson.

As Table 1 in Exhibit 3 illustrates, the exact ratio of tax hikes to spending cuts canchange these numbers somewhat. Yet, for illustrative purposes, our calculationignores interest payments, most likely making these estimates low compared to therevenue that would actually be needed to balance the budget. Morevoer, they areall significantly higher than the Ryan Plan, which raises 19 percent of GDP, andwould also most likely be above 20.6 percent of GDP, the highest amount of taxes


EXHIBIT 2

Progress On The 10-Year Window Will Mask Longer Term

Problems With Entitlement Spending!

Source: HPSInsight, Based on CBOs Alternative Fiscal Scenario plus 0.5% of GDP in tax hikes ($1 trillion over ten years) and

annual spending cuts of $100 billion ($1 trillion over ten years), exclude net interest payments!!

14

16

18

20

22

24

26

PercentofGD

P(%)

2015

2014

2013

2023

2016

2020

2019

2021

2017

2018

2022

2024

2025

2026

2028

2030

2027

2031

2029

2032

Spending (Non-interest)!Taxes!

The ten-year windowsuggests increased tax

revenue and some

small cuts may be

adequate, but

Republicans fear the20-year window. !

10-year window moves us closer

towards primary budget balance! 20-year window highlights long-term problems!

26!

24!

22!

20!

18!

16!

14!

A 1:1 10-Year Deal Applied Over 20 Years !


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collected by the federal government set at the height of the dotcom bubble in2000.

Ultimately, offers that push entitlement reform into the future are simply askingRepublicans to negotiate the real Grand Bargain from a default position of a

higher tax base and a larger government.

Recipe for Gridlock or Opportunity for Compromise?

While the politics of entitlement reform can be tricky, recognizing it as essential fora balanced approach to avoid the fiscal cliff may actually open up room forcompromise. The Congressional Budget Office estimated the savings from many

types of entitlement reforms by 2020. They actually do not raise much money. Forexample, gradually raising the Medicare eligibility age saves a paltry $30 billion.Simply put, systemic reforms to entitlements save little over the typical ten-yearbudget window.

This means that a deal including entitlement reform could skew toward the richpaying more in the near-term, pleasing the Democrats, and more significant and realspending cuts over the long-term, pleasing Republicans.


EXHIBIT 3

0

1

2

3

4

5

6

7

What Happens When We Have To Solve This Problem Again In 10

Years? More Taxes.!

Source: HPSInsight, *Based on CBOs Alternative Fiscal Scenario plus 0.5% of GDP in tax hikes ($1 trillion over ten years) and

annual spending cuts of $100 billion (1 trillion over ten years)!!

PercentofGDP

Total Fiscal Consolidation toGet to Primary Balance!2023 GrandBargain!

2013 Grand

Bargain!

To close the

remaining gap,Republicans will

be asked to

compromise

based on the

previous deal.!

Assuming tax changes equaling $1trillion of new revenue over ten years

and no structural entitlement reforms!

Spending Cuts($ Trillions)! "Taxes as a % of GDPto Balance Primary

Budget in 2032!0.6! 22.8 %!1! 22.0 %!

1.5! 21.4 %!2! 20.9 %!3! 20.4 %!

Table 1!

1st

Deal!

2nd

Deal!

Tax Hikes!Spending Cuts! Total!

1st 10 Years!

Next 10

Years!

6!

5!

4!

3!

2!

1!

0!

7!A 1:1 10-Year Deal Applied Over 20 Years !

Balancing on the Cliff

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