Economics professor shares his view on fiscal cliff
David Flynn, professor of Economics and director of the ND Bureau of Business and Economic Research, shares his thoughts on the fiscal cliff and the potential impact of corrective measures to aid the economy.
What is the "fiscal cliff"?
Flynn: Actually it's overstated by the media to some extent.
There's this perception when your see national media reports that we're going to wake up on Jan. 1 with significantly less money in our pockets. It's not that kind of an immediate problem – so it's not really a 'cliff.'
Many of the changes that would occur after we go over the 'fiscal cliff' would not take effect until after you file your 2013 tax return in 2014. However, some changes will matter sooner, such as the alternative minimum tax. There hasn't been a patch for that, so when you file your 2012 taxes next year, the AMT will affect more taxpayers if it is not patched.
The Social Security tax increase also will affect wage earners take-home pay immediately. But the notion that there's going to be some drastic, instantly noticeable change is not the case. The changes that would result if no compromise is reached on the federal budget – the so-called fiscal cliff – will phase in over time.
This cliff may be an appropriate analogy when you think of things on an annualized basis. But in terms of day-to-day living, you're not going to notice that kind of change.
How did we get here?
Flynn: This situation is the result of a lot of decisions over a great many years where we decided that we weren't going to think long-term about national spending priorities and how we financed them.
We're not just talking income taxes. Various decisions have brought us here, such as the expansion of Social Security benefits or the decision not to up the retirement age, even though people are living and working longer than when Social Security was first enacted prior to World War II. The expansion of Medicare to include drug coverage – Medicare Part D – that was a great big new commitment on the part of the U.S. government at the same that we were planning to cut taxes, without an eye to the fact that we're enjoying excellent economic growth.
So now we have this really big imbalance between revenues and spending. As a country, we have to figure out where we're going to go.
Is there anything the federal government could learn from North Dakota?
Flynn: North Dakota is definitely an example of a different kind of fiscal management. We have a budget surplus, not a shortfall as the feds and many states do.
North Dakota has been consistently more conservative with its growth forecasts and its spending plans. Long-run fiscal management in North Dakota has been much better than the federal government. This state traditionally doesn't run deficits. We've been very cautious about that. Even in lean years, there've been cuts to assure that our budgets were as close to balanced as possible.
What we need to ask at the federal level is what role do we want government to play, how do we pay for it, and who should be paying.
What about taxing the rich to solve this?
Flynn: There are two approaches, political negotiation and economic policy, but it still comes down to priorities.
Taxing the wealthy does generate some additional revenue. What we don't know is how much investment such a tax policy will deter. How many people will not start a business or employ more people?
And here's one of the kickers: with this tax plan, there's an impact on estate tax rates. The estate tax – also known as the death tax – will go back to 55 percent on estate valued at over $1 million; right now it's 35 percent on estates over the $5 million.
That's a drastic change, and it could really bite family-owned businesses. Estate taxes don't apply to corporations, but they do apply to privately owned businesses, including family-owned sole proprietorships, where it gets handed down to the next generation.
The big issue is that people respond to incentives and disincentives, especially with respect to tax policy. So as tax rates go up, if you're having to pay 40 cents out of every extra dollar you earn to the government, that gives you a disincentive to work more hours. Those are the concerns that are out there, especially that with the changes that will occur after we drop off the fiscal cliff, that we're somehow going to disincentivize work, disincentivize family businesses.
How do you see this playing out?
Flynn: Take the two together – taxing and spending – and what we have today is that the government is responsible for a larger share of gross domestic product, which means Uncle Sam has been printing economic activity (essentially deficit spending/borrowing). We'd like to see that come down. It's something like 23 percent, the long-run average is in the 20-21 percent range.
But it's not like we're generating 50 percent economic activity with all that government spending.
So now we have to prioritize: what do we want government to provide?
Unfortunately, every tax exemption in the tax code is there to incentivize something – or disincentivize something. Every government spending program has its supporters, its lobbyists.
This situation is creating uncertainty in the business environment, and that's not good.
You have businesses sitting on the sidelines saying 'we're not going to invest, we're not going to buy new plants and equipment, because we're not sure how it's all going to be taxed, we're not sure how we're going to be allowed to depreciate it, and we're not going to hire.' Their financial statements are up in the air.
So they sit on the sidelines with cash and say 'we're just going to wait and see.' What's going to happen? Well, they find that they don't really need as many workers, they cut back on R&D spending, which means we get less innovation. We reduce productivity growth. We reduce potential gross domestic product, thus, reduce future taxable income.
There's a short-term solution, but then we'll be back in the same place in nine months.
No one is willing to cut government spending to the level it needs to be cut to reduce the budget deficit.
A balanced budget by 2020 would require spending cuts totaling $1 trillion – simply not politically feasible – involving deep cuts to popular programs. So, you have to engage in revenue generation exercises. That could mean getting rid of tax exemptions. But I'd like to see them try it, because every one of those exemptions and credits has lobbyists lined up to advocate and justify why they need to be there.
You're going to need to consider high tax rates, and there's going to be some pain.
Juan Miguel Pedraza
University Relations Writer/Editor
David Flynn has researched the success of North Dakota's economy as well as small business survival in rural South Dakota. He received his undergraduate degree from Boston College and his Ph.D. at Indiana University – Bloomington.