Peter Orszag on Fiscal Policy

Peter Orszag writes for the New York Times. He goes off his Obama administration position, calling for only a two-year extension of the expiring Bush tax reductions, and for America to fight the recession now and fight the long-term deficit later.

I wish he had drawn a clearer distinction between what he regards as first-best policy--higher taxes on the rich, a VAT, lower income taxes on the middle and the working class--and what he regards as a politically attainable compromise. And I wish he were calling for more steps to boost the economy now--not just more short-term deficit spending, but more expansionary monetary and banking policy.

But it is very nice to have his voice back.

What he says our big problem is:

One Nation, Two Deficits: The nation faces a nasty dual deficit problem: a painful jobs deficit in the near term and an unsustainable budget deficit over the medium and long term...

What our best policy would be:

In the face of the dueling deficits... extend the tax cuts for two years and then end them altogether. Ideally only the middle-class tax cuts would be continued for now...

Why this is the best policy in the short term:

[O]ver the medium term, the tax cuts are simply not affordable. Yet no one wants to make an already stagnating jobs market worse over the next year or two, which is exactly what would happen if the cuts expire as planned. Higher taxes now would crimp consumer spending, further depressing the already inadequate demand for what firms are capable of producing at full tilt. And since financial markets don’t seem at the moment to view the budget deficit as a problem — take a look at the remarkably low 10-year Treasury bond yield — there is little reason not to extend the tax cuts temporarily...

Why this is the best policy in the long term:

A benign bond market, however, is a luxury we won’t enjoy forever... our fiscal trajectory is unsustainable and market sentiment may therefore shift quickly and unpredictably... as the economy recovers, the dominant problem will move from depressed demand to excessive budget deficits... we’re not going to solve our budget problem over the next decade unless revenue is part of the equation....

The projected deficit for 2015 is 4 percent to 5 percent of G.D.P., depending on whose assumptions you use. A sustainable level is more like 3 percent or lower. So we need deficit reduction of 1 percent to 2 percent of G.D.P., or about $200 billion to $400 billion a year by 2015.... The health reform act included substantial savings in Medicare and Medicaid, so there aren’t further big reductions available there in our time frame. The other half of the budget is mostly net interest... and discretionary spending... defense... already assumes a phase-down in both Iraq and Afghanistan.... It would be tough, then, to squeeze more than a half percent of G.D.P. from spending by 2015. Additional revenue — in the range of 0.5 to 1.5 percent of the economy — will therefore be necessary to reduce the deficit to sustainable levels.

How would we do this? One possibility would be... revenue-increasing tax reform... a modest value-added tax (that is, a V.A.T. of 5 percent to 6 percent). This approach has many potential benefits, including the opportunity to improve our tax code by cutting back on loopholes and shifting toward a consumption-based tax system. It is also politically impossible... in the era of the 60-vote Senate. Those who fear a V.A.T. have little reason to worry — the votes aren’t there...

What is the political picture:

In the face of the dueling deficits, the best approach is a compromise: extend the tax cuts for two years and then end them altogether. Ideally only the middle-class tax cuts would be continued for now. Getting a deal in Congress, though, may require keeping the high-income tax cuts, too. And that would still be worth it....

The beauty of extending the tax cuts for only two years is that canceling them doesn’t require an affirmative vote. It happens by default, so Congressional deadlock works in its favor. And it would essentially solve our medium-term deficit problem, reducing the deficit by $200 billion to $350 billion a year from 2015 to 2020.... Some may complain that higher marginal tax rates.... It’s hard to believe, however, that effectively returning the tax code to its 1990s form would lead to economic catastrophe... middle-class and lower-class families would be saddled with higher taxes. That’s a legitimate concern, but also a largely unavoidable one if we are to tackle the medium-term fiscal problem.... [A]ctually ending the tax cuts in 2013.... will surely require a presidential veto on any bills to extend them after that.... Minimizing this risk requires as much upfront clarity and commitment as possible, including a strong and unambiguous veto threat from the president....

Senate Democrats and Republicans almost never come together anymore. This month, they should fight the dual deficits rather than each other. Let’s continue the tax cuts for two years but end them for good in 2013.