Cut Spending + Raise Taxes = Budget Problem Solved? It's Not That Easy

One of the myths that has grown up around the budget debate in Washington is that tax increases and spending cuts are just two sides of the same coin. Every week, it seems, some well-meaning group calls on the Republicans and Democrats to agree to a simple formula: the Republicans would agree to tax increases and the Democrats to spending cuts. There. A “grand bargain” it’s called, a bipartisan compromise.

Unfortunately, it’s not as simple as that, and the problem is not—as it might first appear—a question of how much each side has to give up. There are important differences between tax increases and spending cuts that have to be understood before the budget controversy can be resolved in that way.

Spending continues from year to year. Each year, Congress decides how much to appropriate for government programs. Tax increases, however, are done once. When a new tax is enacted it continues to produce revenue from year to year—or slow economic growth, or both—without further need for action by Congress.

So for purposes of understanding the deal the Republicans are asked to accept, the major difference between spending and taxing is that spending is a continuing process, while taxation is done once but has continuing future effects. 

This difference throws light on an obvious problem with the “grand bargain” envisioned by the legions of the starry-eyed. 

If the Republicans agree to taxes in return for cuts in spending, they have given up their bargaining chip; they have no further leverage either to effect further spending cuts or to enforce the cuts on which any agreement was reached—except of course to agree to additional taxes. This is exactly the pattern that caused Newt Gingrich to scorn the pre-1994 Republicans as the tax collectors for the welfare state.

What does this tell us about how to resolve the current budget disputes in Washington? It makes no sense for Republicans to agree to tax increases unless they can be sure that any additional revenue goes to reduce the deficit rather than to fuel more spending. This is far more difficult that it seems. 

When the president calls for taxes on the “rich,” for example, he says the additional revenue should go for new spending on his priorities, not to reduce the deficit. And even if President Obama agrees to cut future spending a credible enforcement mechanism is devilishly difficult to design for the federal government.

Most of the states are required by their constitutions to balance their budgets. This works as a real restraint not because it’s a law—the imaginative use of accounting to evade legal restrictions is a hallmark of governments —but because the states can’t print their own money. Thus, unless they can persuade the financial markets that they have credible revenue sources for repayment they cannot continue to borrow.

But the federal government does not face that kind of market discipline. This is both a blessing and a curse. It can borrow the money to meet its obligations even when it is heavily in debt, and can do so because it can always print the currency in which its debts will be paid. But this means there is no outside restraint on U.S. indebtedness except the political process—and in case you haven’t noticed, that’s not working especially well.

At some point, of course, the debt-financed spree must come to an end. If the U.S. political system cannot gain control of its spending and its debt, the financial markets will eventually conclude that the U.S. can only meet its obligations by degrading the value of its currency; when that idea takes hold, the U.S. will have difficulty borrowing, interest costs will spiral out of control, and the country will have lost the financial and security advantages it currently derives from the power to print the currency with which it pays its bills.

Under these circumstances, it would be foolish for the Republicans to agree to a tax increase unless there is a mechanism in place that credibly puts a ceiling on spending and assures that promised cuts actually take place over time.

It is doubtful, though, that this test can be met. Given the dire condition in which we find ourselves today—having let this issue fester for too many years—a constitutional amendment will take too long, and would still be susceptible to accounting manipulation. 

A spending ceiling like that proposed by House Speaker John Boehner, makes sense in the abstract, but it is also subject to accounting tricks and the mechanism for enforcement is unclear. How could anyone be sure that a future Congress won’t repeal the ceiling, or fill it full of exceptions for favored constituencies?

In the absence of a credible mechanism for assuring that promised cuts in spending will actually take place, the “grand bargain” is an illusion.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. He was General Counsel of the Treasury and White House Counsel in the Reagan administration.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. His new book is "Hidden In Plain Sight: What Caused the World's Worst Financial Crisis and Why It Can Happen Again" (Encounter Books, January 13, 2015).