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How to avoid triggering a financial crisis and fix the US budget deficit in six easy steps

By Saul Eslake - posted Friday, 5 August 2011

Winston Churchill supposedly once said, apropos of whether the United States would enter World War II (on the side of Britain and its then diminishing number of allies), that "you can count on the Americans to do the right thing, after they've tried all the alternatives". The past few weeks' shenanigans in Washington, culminating in a death's door deal to raise the statutory ceiling on the amount of US government debt outstanding and to commit to some meaningful reductions in the US budget deficit over the next year, thereby avoiding the prospect of the US Government defaulting either on its obligations to its creditors, or its commitments to pensioners, employees, suppliers and others, suggests that Churchill's aphorism remains valid.

The threat by Congressional Republicans to vote down any attempt to raise the debt ceiling was in many ways reminiscent of the Liberal and Country (as they were then) Parties' blocking of supply to the Whitlam Labor Government in 1975 – with the crucial difference that there is no Governor-General in the American political system to break the deadlock, as eventually happened here. Rather, the American equivalent of our Governor-General – the President of the United States – was one of the protagonists in the confrontation over the statutory debt ceiling which now seems to have been resolved by a workable compromise.

The fact that all of the key parties to this compromise – House Republicans, Senate Democrats and the Obama Administrations – all found plenty to dislike about it underscores the reality that it is a genuine compromise, and provides some reason for confidence that its key provisions will be acted upon.


In the short term, the most important result of the compromise is that, by increasing the debt ceiling by at least US$2.1 trillion, the threat of an imminent default on US Government obligations will not arise again until at least 2013. That means that this Damoclean sword will not be hanging over the global financial system through what is likely to be a bitterly contested Presidential and Congressional election year in 2012.

Second, US$900 billion of expenditure reductions over the next ten years have been 'locked in'. This is by no means enough to put the US' public finances on a sustainable footing – the non-partisan Congressional Budget Office projects that the US will run up budget deficits totalling US$6.7 trillion over the next decade on unchanged policies, and almost US$9.5 trillion if the Administration's 2012 Budget were enacted in full. The compromise agreement also includes a commitment to find an additional US$1.5 trillion in additional spending cuts through a bipartisan committee whose recommendations will attract the same 'fast track' status as trade agreements – that is, they can be passed or rejected by either House but not delayed or amended as usually happens with other legislation in Congress.

True, the track record of efforts to reach agreement on meaningful deficit reduction measures through bipartisan committees or commissions in recent years doesn't inspire a lot of optimism. But this agreement is backed up by a legislated commitment to 'sequester' (a Congressional expression for 'freeze') expenditures unless at least US$1.2 trillion in deficit reduction over the next decade is agreed by 2013.

Third, the compromise includes, among the US$900 billion of savings committed to 'up front' over the next decade, some $US350 billion out of the 'baseline' defence budget (that is, abstracting from savings resulting from the winding down of US troop commitments in Iraq and Afghanistan).

And the 'sequester' arrangements provide for half of any further savings resulting from the operation of those arrangements, if they are triggered, to come out of defence. That's an area where there's plenty of room for savings, but up until now Republicans have been particularly unwilling to agree to them.

Fourth, the bipartisan committee tasked with finding an additional US$1.2 trillion of deficit reductions over the next decade will be empowered to consider 'tax reforms' as well as spending cuts. That's critical because – notwithstanding the vehemence of 'Tea Party' Republicans on this score – it's fatuous to think that deficits totalling somewhere between U$6.7 and $9.5 trillion over the next decade can be substantially reduced, let alone eliminated, solely by spending cuts. Not only is that unfair, by any reasonable interpretation of that often ideologically-laden adjective, but it is simply unrealistic.


In this US fiscal year that ends next month, total US government revenues will amount to the equivalent of 14.8% of US GDP. That's the lowest percentage since 1950, and back then US Federal Government spending was only 15.6% of GDP, compared with what is expected to be 24.3% of GDP in the current fiscal year. The lingering effects of the most severe recession in US post-war history have of course punched a big hole in tax collections, but over the next decade are expected to average 18.7% of GDP – though that includes the increased revenue coming from the expiry of the Bush Administration's tax cuts, originally scheduled for 2010 but now postponed until the end of fiscal 2012, and something to which the Congressional Republicans are implacably opposed.

But there are plenty of options for increasing revenues without increasing tax rates. For example, eliminating the tax deductibility of mortgage interest payments (something Australian homebuyers do perfectly well without, despite paying higher interest rates on average than American homebuyers) would reduce the deficit by US$215 billion over a decade1. Capping the deduction which Americans can claim against their Federal income tax liabilities for taxes paid to State and local governments (again, something we Australians don't get, although we don't pay as much tax to State and local governments as most Americans do) would reduce the deficit by US$629 billion over a decade. Increasing the ceiling on personal income subject to the Social Security tax (a flat tax on incomes which pays for what Americans call 'Social Security', which we call the age pension) from its present level of US$106,800 to (say) $170,000 would reduce the deficit by US$456bn over a decade. And since high-income earners in America get the pension (which they don't here), it doesn't seem unreasonable that they should pay for it at the same rate as those less well-off than themselves.

That's three simple changes to the US income tax code – changes which Australians would regard as totally unobjectionable – which would reduce the US budget deficit by US$1.3 trillion over the next decade.

Then, if Congress really wanted to nail it, they could introduce a 5% GST (half the rate of Australia's) on a broad base (but nonetheless excluding rents, education, financial services, and government-reimbursed health care expenses) which, according to the Congressional Budget Office, would raise US$2.5 trillion over a decade.

Those four measures, combined with the spending reductions agreed to (in outline) in this week's bipartisan compromise, would be just about enough entirely to eliminate the Congressional Budget Office's 'baseline' estimates of the US budget deficit over the next ten years. But I'm not holding my breath.

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This article was first published in the Melbourne Age on August 3, 2011.

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About the Author

Saul Eslake is a Vice-Chancellor’s Fellow at the University of Tasmania.

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