What Should Be Done About the Fiscal Cliff

Everyone is talking about the “fiscal cliff”—the likely impact of the expiration of the Bush tax cuts and the planned cuts in government spending that are part of Budget Control Act of 2011. Much discussion about the fiscal cliff, and its likely consequences, however, is misleading. The media have emphasized how a tax increase or cut in government spending will reduce overall spending in the economy so that firms have to cut back production and lay workers off. We should be much more concerned about how the fiscal cliff affects investment and entrepreneurship than how it affects aggregate spending. This is why allowing tax rates to rise, especially on the rich, will do more harm than good.

Republicans and Democrats claim that they want to reduce the government deficit, which (some argue) would require some combination of tax increases and government spending cuts. Many are convinced that both the government and also American families need to spend more to bring the rate of unemployment down. If taxes are increased, households and businesses will reduce their spending. This reduction in private spending, especially when combined with a reduction in government spending, may cause a recession.

Although increasing taxes and cutting government spending may have negative short-run effects, a more fundamental question is how the U.S. economy can return to a faster long-run rate of growth that will make it possible for the millions who are now unemployed to return to work. Contrary to popular belief, the primary reason for the poor performance of the U.S. economy is not that Americans are spending too little. It is rather that businesses are not investing enough in capital equipment and are not willing to hire people because of uncertainty about the future of the economy. Reducing government spending and borrowing, particularly if the spending cuts are permanent and not temporary, may actually give people greater confidence to invest and start businesses.

The biggest problem with raising taxes is not that people will spend less. Higher tax rates influence the incentive to work and invest. If entrepreneurs and investors expect the government to take 40 cents or more out of every additional dollar they earn, many are going to be less inclined to take the extra risks associated with expanding their businesses and hiring more workers. If, however, the government were to increase its tax revenue by eliminating loopholes in the tax code, the incentive to work and invest would be affected much less than by an increase in tax rates. Certain provisions in the tax code, like the mortgage interest deduction, reward people for doing things that do not help and may actually hinder the long-run growth of the economy. Incentives are the key to a healthy economy, so tax increases are most harmful if they reduce incentives to work and invest, which happens when government requires workers and investors to pay a higher percentage of each dollar earned.

Why can’t the two sides compromise for the sake of being fiscally responsible—combining moderate tax-rate increases with spending cuts? The debt of the federal government is so large that the token spending cuts being considered by politicians of both parties will do little to prevent government bankruptcy. If the federal government used accounting standards that businesses use, it would record government debt as much higher than the official figure of $16-plus trillion. The reported federal government debt excludes trillions of dollars of unfunded Medicare and Social Security benefits that workers expect to receive when they retire in exchange for the taxes they paid during their working years. If a compromise could be reached that involved cuts in promised Social Security and Medicare benefits large enough to make those programs sustainable, it might be worth considering.

A tradeoff exists between short-term stimulus of the economy and long-term growth. It may be that cutting government spending would slow the growth of the economy in the short run, but that is not a foregone conclusion. The resulting reduction in government borrowing would mean that more of the money people save would be available to finance private investment. Increased investment would lead to more and higher-paying jobs.

Continuing to postpone steps to drastically reduce government spending, though it may modestly help the economy in the short run, is not the answer. Raising tax rates, however, will do little to address the long-run debt problem of the U.S. government and may just make it easier to delay needed spending reductions. Limiting the share of income taken in taxes and cutting government spending will encourage firms to invest in capital and hire more workers, especially if combined with steps to roll back some of the recent increases in regulation of health care and the financial system, which have contributed so much to uncertainty about the future.

Editor's note: This column was originally published on Forbes.com.