The more you think about it, the more it becomes clear that Republicans did far better in the tax negotiations than one might have expected. One might even say that they won.
To see why, remember that the fiscal cliff was really two cliffs: an impending tax hike and an impending spending reduction. Let’s consider each in turn.
On taxes, Republicans wanted to sustain lower tax rates for everyone and also defend lower dividend, capital gains and estate taxes. Democrats wanted to extend the Bush tax cuts for all but the wealthy.
Given those objectives, the tax negotiation was stacked against the Republicans in every way. Tax hikes were already the law of the land as of January 1st. Republicans’ only leverage was to credibly commit to increasing taxes on everyone in order to defend the tax cuts for the wealthy. But such a position would be entirely inconsistent with the party’s tax-cutting brand identification and, of course, GOP members’ heartfelt belief that higher tax rates will harm the economy.
The weakness of this position was reflected in John Boehner’s first offer after the November election.
Following Obama’s original proposal of $1.6 trillion in tax increases, Speaker Boehner offered the president $800 billion in new revenue for a deal over the expiring tax cuts. That’s $800 billion over 10 years. It seems to have been lost in the shuffle that his first offer was almost $200 billion larger than the tax increase that just passed!
So on the tax side, the final deal is better in terms of overall revenue than the Republicans’ first offer. While the top income tax rate went up more than Republicans might have hoped, they extracted huge concessions on other important tax issues. The estate tax was cut, and the dividend tax rate is now permanently below the income tax rate. The dividend rate is a little higher, but Warren Buffett will still pay a lower tax rate than his secretary and, presumably, still whine incessantly about it.
The deal looks even better when one considers the dynamic effects of the tax increases. The top marginal tax rate is, to be sure, much higher after the deal. But many businesses will respond to this higher rate by changing their organizational form. If they incorporate, then they can take advantage of the statutory corporate tax rate of 35 percent, and avoid the higher tax rates altogether. A little bit of such reorganization could plausibly offset a big chunk of the $600 billion in increased revenue.
So Democrats entered the fiscal poker games with the best cards they will ever have, and left with a 10-year increase in revenue that will likely be far less than 10 percent of the currently forecasted deficit, which the CBO recently projected would top $9 trillion from 2013 to 2022. And this deal etches so much of the tax code permanently that it is highly unlikely that the tax code will be modified again anytime soon. Taxes and tax revenue will almost surely be off the table going forward.
Which brings our attention to spending.
On that, Republicans seem firmly committed to entitlement reforms, whereas Democrats are, to put it mildly, less so. With taxes behind us, the next round of negotiations will focus on spending in isolation, and the key thing to note is that now the roles are reversed and Republicans have all the cards.
If no agreement is reached, then spending cuts that Democrats abhor will happen. What’s better, the Republicans will have three bites of the apple.
There will be a vote of the scheduled cuts (sequestration), a vote over the debt limit and then a vote over a government-wide funding bill that will expire in March. At each point, Republicans should be able to extract concessions from Democrats, increasing the overall cuts and tilting them away from defense.
Those concessions should be all the easier to extract since moderate Democrats are already antsy about passing a tax hike without any real spending cuts. Democrats are united about increasing taxes on the wealthy, but are not nearly as united on spending. Now the issues are separate. Democratic Senator Michael Bennet, for example, voted against the fiscal cliff compromise, citing the necessity of a plan to “put in place a real process to reduce the debt down the road.” With taxes off the table, debt reduction becomes spending reduction.
If no deal is reached, then sequestration will give the Republicans the significant spending cuts they have been seeking since recapturing the House. The odds are they will get much more, and that the total package will be far superior to their initial negotiating position in the fiscal cliff talks. The fact that the tax hikes are so small sets the next round up almost perfectly for Republicans.
Kevin A. Hassett is director of economic-policy studies at the American Enterprise Institute, where he is the John G. Searle Scholar.