Speak softly and carry a big chainsaw
December 13, 2010, 3:00am

America’s budget deficit: Sorting out America’s fiscal mess is relatively simple. What’s needed is political courage.

LAST week Asia, this week Europe: no wonder Barack Obama has been to so many foreign summits since his party took a pounding in the mid-term elections. With the prospect of gridlock at home, a president naturally turns abroad. Yet Mr Obama badly needs to show that he can still lead on domestic policy. He should start by cajoling Congress into an agreement to tackle America’s ominous fiscal arithmetic.

Conventional wisdom says such an agreement is impossible: the problem is too big, the politics too difficult. But it is wrong to suppose that the deficit is unfixable, as two proposals for fixing it have shown this month (see article). And even the politics may not be totally intractable.

A trillion-dollar trove

The scale of America’s fiscal problem depends on how far ahead you look. Today’s deficit, running at 9% of GDP, is huge. Federal debt held by the public has shot up to 62% of GDP, the highest it has been in over 50 years. But that is largely thanks to the economy’s woes. If growth recovers, the hole left by years of serial tax-cutting and overspending can be plugged: you need to find spending cuts or tax increases equal only to 2% of GDP to stabilise federal debt by 2015. But look farther ahead and a much bigger gap appears, as an ageing population needs ever more pensions and health care. Such “entitlements” will double the federal debt by 2027; and the number keeps on rising after then. The figures for state and local debt are scary too.

The solution should start with an agreement between Mr Obama and Congress on a target for a manageable level of publicly held federal debt: say, 60% of GDP by 2020. They should also agree on the broad balance between lower spending and higher taxes to achieve this. This newspaper believes that the lion’s share of the adjustment should come on the spending side. Entitlements are at the root of the problem and need to be trimmed, and research has shown that although spending cuts weigh on growth in the short run, they hurt less than higher taxes. And in the long run later retirement and other reforms will expand the labour force and thus potential output, whereas higher taxes dull incentives to work and invest.

Yet even to believers in small government, like this newspaper, there are good reasons for letting taxes take at least some of the strain. Politically, this will surely be the price of any bipartisan agreement. Economically, there is sensible room for manoeuvre without damaging growth. American taxes are relatively low after the reductions of recent years. In an ideal world the tax burden would be gradually shifted from income to consumption (including a carbon tax). But that is politically hard—and there is a much easier target for reform.

America’s tax system is riddled with exemptions, deductions and credits that feed an industry of advisers but sap economic energy. Simply scrapping these distortions—in other words, broadening the base of taxation without any new taxes—could bring in some $1 trillion a year. Even though some of this would have to go in lowering marginal rates, it is a little like finding money behind the sofa cushions. The tax system would be simpler, fairer and more efficient. All this means that America can sensibly aim for a balance between spending cuts and higher taxes similar to the benchmark set by Britain’s coalition government. A ratio of 75:25 is about right.

There is legitimate concern that, done hastily, austerity could derail a weak recovery. But this strengthens the case for a credible deficit-reduction plan. By reassuring markets that America will control its debt, the government will have more scope to boost the economy in the short term if need be—for instance by temporarily extending the Bush tax cuts.

Mr Obama and the Republicans are brimming with ideas for freezing discretionary spending, which covers most government operations from defence to national parks. They have found common cause in attacking “earmarks”, the pet projects that lawmakers insert into bills. But discretionary outlays, including defence, are less than 40% of the total budget. Entitlements, in particular Social Security (pensions) and Medicare and Medicaid (health care for the elderly and the poor), represent the bulk of spending and even more of spending growth.

On pensions, the solution is clear if unpopular: people will need to work longer. America should index the retirement age to longevity and make the benefit formula for upper-income workers less generous. The ceiling on the related payroll tax should be increased to cover 90% of earnings, from 86% now.

Health-care spending is a much tougher issue, because it is being fed by both the ageing of the population and rising per-person demand for services. Richer beneficiaries should pay more of their share of Medicare, while the generosity of the system should be kept in check by the independent panel set up under Mr Obama’s health reform to monitor services and payments. The simplest way for the federal government to restrain Medicaid would be to end the current system of matching state spending and replace this with block grants, which would give the states an incentive to focus on cost-control.

Chainsaw you can believe in

Devising a plan that reduces the deficit, and eventually the debt, to a manageable size is relatively easy. Getting politicians to agree to it is a different thing. The bitter divide between the parties means that politicians pay a high price for consorting with the enemy. So Democrats cling to entitlements, and Republicans live in fear of losing their next party nomination to a tea-party activist if they bend on taxes. Even the president’s own bipartisan commission can’t agree on what to do.

But true leaders turn the hard into the possible. Two things should prompt Mr Obama. First, the politics of fiscal truth may be less awful than he imagines. Ronald Reagan and Bill Clinton both won second terms after trimming entitlements or raising taxes. Polls in other countries suggest that nowadays tough love can sell. Second, in the long term economics will tell: unless it changes course, America is heading for a bust. If Mr Obama lacks the guts even to start tackling the problem, then ever more Americans, this paper and even those foreign summiteers will get ever more frustrated with him.