Orszag: A good deal will raise tax rates, fix entitlements

Although it isn't yet time to panic about the fiscal cliff, negotiations so far aren't exactly going well. The Republicans are committing themselves to an unsustainable principle of no marginal tax-rate increases whatsoever. And the Democrats are failing to seize the moment to make progressive reforms to Medicare and Social Security.

There's still time to come to an agreement to prevent the more than $600 billion in federal spending cuts and tax increases scheduled to take effect in January while also raising the debt limit, but both sides will need to get out of the boxes they have put themselves in.

Let's start with the Republicans. Their adamant opposition to an increase in marginal tax rates for anyone, anywhere, has two problems. First, as I explained in last week's column, raising huge amounts of revenue by reducing tax expenditures gets harder to do as the details become clear. The only practical way to hit a reasonable revenue target is to have some increase in marginal rates.

The second problem is that hard-and-fast principles can look increasingly ridiculous when taken, by opponents, to their logical extremes. Imagine some clever but Machiavellian Democrat (Senator Charles Schumer of New York comes to mind) proposing that the top marginal tax rate be increased to 35.5 percent, from 35 percent, for people with income above $5 million. Would the Republicans really blow up a deal over an almost undetectable increase on a tiny number of extremely high-income taxpayers? That would be political suicide. On the other hand, if the Republicans accept this increase, then they don't have a principle anymore.

Waning Support

On this issue, Republicans are losing the support of even leading chief executives and K Street lobbyists. Randall Stephenson, the CEO of AT&T Inc., for one, recently stated that a deal "will require a compromise involving an increase in both tax rates and revenue in return for real and significant steps to reform entitlements and rein in federal spending." Note that Stephenson's statement specifically mentions higher tax rates.

On the other hand, it also reminds us that the negotiations are about more than taxes. There is also the debt limit, which, according to the best guesses of both the Congressional Budget Office and the Bipartisan Policy Center, will be reached in the first quarter of 2013.

So the question for the Democrats is: Even if you win higher marginal tax rates, how do you plan to get the debt limit increased? The Republicans, after all, could cave on raising taxes but still be unwilling to include a debt-limit increase in the agreement, absent any changes to entitlements. In that case, the fiscal-cliff victory would be Pyrrhic, with another crisis arriving in February or March.

In any case, Democrats should affirmatively want entitlement reform that is progressive and puts the crucial programs on a sounder footing.

On Social Security, as I have previously argued, the Democrats, while they still control the White House and the Senate, should want to lock in the victory they have already won over the idea of keeping private accounts out of Social Security. Plus, as Peter Diamond and I have laid out, it's possible to restore the program's long-term solvency while also making it fairer -- including by having it reflect the growing gap in life expectancy by income and education. Finally, and perhaps most important, Social Security reform can be phased in gradually, thereby minimizing the damage to the labor market from too much austerity too soon.

Difficult Reform

I'm not pretending that Social Security reform is easy. It must, though, be compared with the alternatives. Progressive Social Security reform not only would be affirmatively desirable but also could partially displace other, more troubling proposals -- which would take effect too quickly, and thereby raise the unemployment rate, or be problematic on their own terms. It would be difficult, for instance, to make further cuts in discretionary spending, as it is already scheduled to reach unreasonably low levels as a share of the economy.

The administration claims that it is committed to reforming Social Security -- just not right now. But why would reform be easier in, say, 2014, when nothing is forcing action, than it is today? (And if the problem is that Republicans are reluctant to vote for additional revenue as part of Social Security reform, how exactly does that change over the next year or two?) To date, Barack Obama's administration has basically just repeated its previous budget proposals for Medicare, which are perfectly fine and desirable as far as they go. To go further, the Center for American Progress recently convened a group of health policy experts (including me), which put forward a dozen proposals to slow the growth of health costs over the coming decades. Although these changes don't generate significant "scoreable" savings because their effects are too uncertain for the Congressional Budget Office to fully evaluate, they may well have a larger impact on our long-term fiscal future than anything else that could possibly be contained in the budget deal.

The optimistic view is that, so far, the two sides are just positioning. After all, if a deal were reached weeks ahead of the deadline, both sides would worry that they gave too much. But this week and next are when both Republicans and Democrats need to show more flexibility.

Peter Orszag is vice chairman of corporate and investment banking at Citigroup Inc. and a former director of the Office of Management and Budget in the Obama administration.