With attention on Europe's economic mess, it would be easy to forget that America's intractable fiscal problem is coming to a head. The choice of Paul Ryan as Mitt Romney's running mate should bring this back into focus.
The US budget challenge plays out over two different time horizons. First, there is the exigent 'fiscal cliff'. Various budgetary measures will lapse at the beginning of 2013: the Bush tax cuts, temporarily more generous unemployment entitlements, payroll tax cuts and various one-off spending initiatives. If all these measures lapse, the deficit would certainly improve, falling from its present 7.5 per cent of GDP to average just over 1 per cent over the next decade. Government debt would stabilise at around 60 per cent of GDP.
But if nothing is done to soften the impact, this would impose a contractionary shock equal to around 4.5 per cent of GDP. This would be devastating, even for a healthy economy. Even the most resolute budget reformer will not stand back and let the economy fall over this fiscal cliff.
Whatever is done to address this immediate problem, however, sets the starting point for tackling the medium-term problem: the unsustainable deficit. If, instead of letting these measures lapse, they continue at around present levels, the deficit will average over 5 per cent of GDP and the debt will quickly rise to over 90 per cent of GDP. In the longer term, things get even worse with the demographically-driven rise in health and social security entitlements.
Just what action the newly elected (or re-elected) president will take to ease the fiscal contraction is constrained by his ideology. How can any amelioration of the fiscal cliff be reconciled with the only slightly less urgent problem of grinding down the deficit, enforced by the rising debt burden?
Both presidential candidates acknowledge that the medium-term fiscal position is unsustainable. On the surface Obama has the harder task, as he will want to fund a more generous welfare state (including his pet Obamacare health initiative).
Enter Paul Ryan into the debate.
Of course Ryan is candidate for vice-presidency, not the presidency. Romney has already had to make clear that he, Romney, is in charge. But Ryan is the budget expert: he is Chair of the House Budget Committee, and has offered a series of detailed budget proposals over the past couple of years. He was also a member of the 2010 bipartisan Bowles-Simpson Commission that proposed a mix of revenue increases and expenditure cuts (his dissent from the Commission's revenue proposals helped to torpedo the initiative). His ideas will have to be the basis for any Republican budget plan.
His over-riding aim is to get the top tax rate down from 35 per cent to 25 per cent. He says this can be done by widening the base – reducing the multitude of exemptions and deductions, closing loopholes and achieving better enforcement. Paradoxically, with Romney now acknowledging that his own tax rate is not much more than 13 per cent, there is hard evidence that getting the rich to pay the proposed reduced rate would, in fact, be positive for revenue.
But it's one thing to have 'outed' the tax rate of one rich individual; it is another to provide specifics on the base-widening. And for good reason: each one of the exemptions and loopholes has its own vigorous defenders. Not only do they vote, they also make political contributions. This political reality is inconsistent with Ryan's forecast that his measures will raise revenue by 4 per cent of GDP by 2028.
That said, there is ample opportunity to enhance revenue. The Tea Party's bleatings might give the impression that Americans are heavily taxed. Judged by international comparisons, however, this is far from true. America has no federal VAT/GST. Given the huge redistribution of income to the very rich over the last couple of decades, a concerted effort to tax the rich, even at an effective rate of 25 per cent, would go a long way to fix the US budget problems.
Thus the most radical element of the Ryan proposals is not on the revenue side. But his proposals do imply a revolutionary slimming of the government role, at a time when most countries are shifting inexorably in the other direction: government services are a 'superior good' which people want more as they get richer (and older).
The Ryan proposal to transform Medicare (which looks after those over 65) into a voucher-based scheme is not, in economic terms, all that radical: similar schemes operate successfully in a number of countries. Medicaid expenditure (for poor under-65-year-olds) would be halved. These are tough measures, but toughness is needed to rein in both overall health costs (the US spends around 5 per cent of GDP more on health than similar countries) and the proportion met by the budget.
That leaves the truly radical elements in 'discretionary' expenditure, outside health, social security, debt interests and defence; economist Jeffrey Sachs wrote in the Financial Times that this includes areas such as education, job skills, infrastructure, science and technology, space, environmental protection, alternative energy and climate change adaptation. These expenditures would fall from 12 per cent to 6 per cent by 2020, and halve again by 2050. With defence off limits for cuts by Republicans, this leaves nothing for all other discretionary expenditures.
It is possible that the Ryan proposals are just camouflage for a repeat of the Bush sequence, where tax rates for the rich are cut but the revenue offsets never eventuate, leaving the budget deficit unresolved. David Stockman, the Republican-appointed former director of the Office of Management and Budget, says Ryan's proposals are 'devoid of credible math or hard policy choices'.
But at least on the election hustings, Obama can use the proposals as a debating target to correct his own budget inadequacies. He can toughen up his budget stance while giving it specific content and credibility. He could borrow Ryan's revenue base-widening ideas (while retaining his own tax rate), and rein in health costs more vigorously. He can do this knowing that the Republican alternative, taken at face value, promises to give America a third-world government sector.
Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.