It's Time to Cut a Deal on the Federal Budget

We will soon find out if Chili Palmer was right when he said, "Sometimes you do your best work with a gun to your head."

According to received wisdom, Washington needs to hash out a budget deal to avoid the fiscal cliff that is partly the result of another deal, the Budget Control Act of 2011, which imposed automatic spending cuts if the congressional super-committee on deficit reduction could not reach its own deal. Which, as things turned out, it couldn't.

Economists say letting the cliff's cuts proceed at the same time the Bush tax cuts expire would be doubleplusungood, and Beltway officialdom appears to believe them. So we will soon find out if Chili Palmer was right in "Get Shorty," when he said, "Sometimes you do your best work with a gun to your head."

But first, the kabuki, in which the players stake out their initial bargaining positions. Like the opening bids at a Persian rug bazaar, those will be haggled down.

What should a final deal look like? There's the utopian version, and then there's reality.

The liberal utopia jacks up taxes on the dirty evil rich while leaving social-welfare spending untouched. The conservative utopia slashes spending on shiftless welfare slackers while leaving taxes unraised. But since conservatives hold the House and liberals hold the White House, neither one of these utopias will happen. Everybody will have to give something. Such as what?

(1) Tax hikes. There are sound reasons to oppose higher taxes: Tax receipts have returned to an almost historic high, and higher rates will lock in a long-term source of revenue to fuel government growth. But there is also a sound reason not to: The wars in Iraq and Afghanistan were largely financed through debt. Fiscal conservatives should have insisted on pay-as-you go, but better late than never.

Anyway, Democrats hold all the cards. The Bush tax cuts will expire for everyone come Jan. 1. Republicans have a choice between half a loaf—restoring the cuts for some—or no loaf at all. Seems like an easy call. They can save face by negotiating the cutoff for higher rates. Virginia Sen.-elect Tim Kaine has suggested a compromise—$500,000 instead of the president's $250,000—which amounts to a half-trillion dollars over 10 years. Republicans should accept.

(2) Defense cuts. Listening to conservatives caterwauling about defense cuts, you might get the impression they think government spending creates jobs or something. Of course, in all other instances they insist government bloat hurts the economy. Conservatives also lament the decline in defense spending relative to other budget categories—as though the Pentagon should get more money whenever social spending goes up, just to keep the ratios steady. Yet they ignore the fact that as a proportion of world military spending, the U.S. accounts for 46 cents out of every dollar.

The fiscal cliff's cuts would trim the Pentagon by 12 percent, which would whack it all the way back to the appropriation levels of … 2007. Doesn't sound too catastrophic. A cut half that size would be even less so.

(3) Social-welfare cuts. In recent years social-welfare spending, already gargantuan, has exploded. It's up more than 40 percent just since President Obama took office. At more than half a trillion dollars, Medicare alone approaches the size of the defense budget—and unlike defense, will see its outlays nearly double by 2020. Food-stamp enrollment also has spiked under Obama—yet as the journal National Affairs points out, "among recipients of federal food-stamp benefits, there are more people above the poverty line than below it." Ditto Medicaid: "Most … beneficiaries are over the poverty line." Starting next year Obamacare's health-insurance subsidies will be available to those earning up to four times the federal poverty level. There's a word for countries that give ever-bigger benefits to an ever-increasing pool of recipients: bankrupt.

(4) Spending cuts generally. President Obama's "balanced" approach actually is tax-heavy—which gets things exactly backwards. As Harvard's Alberto Alesina explains in City Journal, data from the International Monetary Fund show that "when governments reduce deficits by raising taxes, they are indeed likely to witness deep, prolonged recessions. But [reducing deficits through] cutting spending resulted in very small, short-lived—if any—recessions." That's owing to "private investment…. [P]rivate-sector capital accumulation rose after the spending-cut deficit reductions, with firms investing more in productive activities—for example, buying machinery and opening new plants. After the tax-hike deficit reductions, capital accumulation dropped."

Bottom line: "Tax-based deficit reduction … is always recessionary." That point should swing a lot of weight just now, when Congress and the White House are trying to cut the deficit without cutting off the fragile recovery. There are good deals and there are bad deals. We've had quite enough of the latter for now.