The Looming Showdown

Come next January, our dysfunctional system will have to function.
Here’s one possible path toward an outside-the-box budget deal.

By Peter Orszag

Tagged budgetTaxes

It’s January 2013. The treasury secretary has warned that we’ve run out of maneuvering room to avoid hitting the debt limit again, bringing back memories of August 2011. This time, though, the debt-limit drama is happening at exactly the same time as contentious debates over the massive spending cuts triggered by the 2011 debt-limit deal and over the 2001 and 2003 tax cuts, which were allowed to expire at the end of 2012 due to political stalemate but are likely to be replaced or resurrected in some form.

This trifecta—debt limit, sequestration on spending, tax cuts—is occurring right at the beginning of a new presidential term, the brief but auspicious honeymoon period for legislative action. Furthermore, even if the rest of 2012 turns out relatively well for economic growth, the labor market will remain weaker than normal in early 2013—which should further motivate legislators to avoid the substantial and immediate fiscal contraction that would occur if the tax cuts and spending cuts were to be implemented in full. If ever there were a time for a big legislative package, early 2013 would be it.

And yet there’s reason to question whether meaningful legislation will emerge from this maelstrom, especially if the President is not from the same political party as the majority in the House and the Senate. Despite mythology to the contrary, divided government has never been particularly conducive to important pieces of legislation—and more importantly, the rise of polarization and the decline of moderates in Congress makes the hurdles of divided government more challenging than they’ve ever been during the postwar era. As a result, it’s entirely possible we’ll have another placeholder or “framework” deal in early 2013—embodying the false hope that with just a bit more time, we could finally reach a more substantial agreement.

The situation in early 2013 is thus a microcosm for examining a new and fundamental dilemma of our political economy, one that is driven by the disappearance of moderates in Congress. National elections continue to be won by appealing to the swing voters in the middle of the political spectrum. (Indeed, because the rise of polarization creates safer bases for each side, it makes centrist swing voters ever more crucial to winning presidential elections.) And yet, after winning national elections by appealing to centrists, politicians quickly learn that actually governing from the center is less and less feasible given the hyperpolarization now reflected in Congress.

Instead, major legislation is more likely to succeed on a partisan basis. But that’s only possible in the rare instances in which one party wins the political trifecta—the White House, the House of Representatives, and close to 60 votes in the Senate. Furthermore, a party that uses those rare moments of political supremacy to enact significant legislation on a partisan basis will typically suffer enough backlash to destroy the temporary dominance.

The United States will thus spend significant periods of time with divided government. And the rise of polarization and the associated decline in congressional moderates means that the harm from such periods is likely to be higher than in the past, since divided government was less debilitating when the center in Congress was more heavily populated.

We need not, however, lose all hope, even with divided government. After all, and however improbable it seems right now, it’s possible that the drama of early 2013 will produce an agreement that avoids undue immediate fiscal austerity while modestly reforming the tax code and entitlement programs.

Imagine, for example, the following scenario that I describe in more detail at the end of this essay: The Administration, having tried valiantly but failing during the lame-duck session to extend the tax cuts only for those with incomes below $250,000, allows all the tax cuts to expire at the end of the year. Taxes rise, the debt limit looms, and commentators on CNBC say the world is about to end.

Rather than continuing the unproductive debate over extending part or all of the tax cuts, though, the Administration then steps forward with an entirely new tax cut, which could take many forms. One example would be a substantially larger payroll-tax holiday, combined with an increase in the standard deduction. The Administration also offers modest entitlement changes while dialing back the immediate spending cuts. Amid all the external demands for a deal that lifts the debt limit and resolves the uncertainty, it then dares the Republican House to vote against a large tax cut and some modest entitlement changes. Stranger things have happened.

The Divided Government Myth

The 1983 Social Security reform bill, the 1990 Andrews Air Force Base budget deal, and the 1996 welfare-reform deal have created an impression, especially among policy-makers and pundits in Washington, that divided government in the United States has historically been more conducive to significant legislative undertakings than unified government. In a 2004 piece in The Atlantic extolling the virtues of divided government, Jonathan Rauch wrote, “Divided control…draws policy toward the center; and by giving both parties a stake in governing, it can lower the political temperature so that even daring changes (tax reform, welfare reform) seem moderate.” Rauch is not alone in suggesting that divided government may not be problematic, and indeed may be more productive than the alternative. The evidence from the political science literature, however, shows that impression is misleading.

No serious political scientist appears to agree with the punditry that divided government has been integral to producing major legislation in the past. At best, the evidence assembled by David Mayhew of Yale in his landmark book Divided We Govern suggests that divided government is about as productive as unified government. Yet even that assessment is likely too optimistic. As Sarah Binder of George Washington University and others have shown, the most rigorous analyses find that divided government is harmful to legislative productivity.

Binder also shows that moderates in Congress are crucial: the fewer the moderates, the bigger the hurdle to enacting significant legislation, a finding consistent with research by Princeton professor Nolan McCarty on legislative productivity during periods of congressional polarization. The decline of moderates, furthermore, is changing the nature of governing even during periods of unified government. Until the past 20 years or so, even when one party controlled the White House and the Congress, major pieces of legislation were traditionally bipartisan. The 1965 legislation creating Medicare is one example; Democrats controlled the White House, House, and Senate, but almost half the Republicans in Congress also voted for the legislation. The 1993 budget deal and the 2010 health-care reform act, by contrast, are likely to represent the new model: major legislation enacted on a partisan basis. Both bills passed without a single Republican vote.

Most of the policy-making and punditry world still yearns for the days of the Medicare deal, but they are largely if not entirely gone. When I became director of the Office of Management and Budget, I was lucky because I had just come from being director of the Congressional Budget Office—and since the CBO is a nonpartisan agency, I had good relationships with many Republicans. At my confirmation hearing, one of those Republicans said that even his Republican friends seemed to like me—and then asked how long I thought this feeling of bipartisanship would last in my new job. He was prescient: Many of those relationships quickly frayed. Indeed, although a few agencies like CBO operate on a nonpartisan basis, there are now remarkably few people in Washington who work well with members of both parties, a reflection of the polarized environment.

The broader lesson for presidents is clear: Unless they have sufficient votes to legislate only with members of their own party, they’re much less likely to enact major legislation—that is, without surrendering key policy objectives to the opposite party.

Where Have the Moderates Gone?

So what’s happened to the moderates? As the data assembled on Voteview.com (a website maintained by political scientists Keith Poole and Howard Rosenthal that contains data on congressional voting patterns) demonstrates, the most conservative Democrats in Congress 50 years ago often voted together with the most liberal Republicans. That common ground was dwindling by the 1980s; today, it is almost non-existent. Much of the shift has occurred because Republicans have become substantially more conservative.

A popular explanation among pundits for the rise of polarization and the decline in moderates is gerrymandering—that districts have been redrawn to make them safe for one party or the other, allowing more partisan representatives. But it’s mostly wrong. One study by Sean Theriault of the University of Texas at Austin showed that only a tenth to a fifth of the rise in polarization since the 1970s can be attributed to redistricting (other estimates are even lower). Nor is polarization just an inside-the-Beltway phenomenon, as some have suggested. From 1996 to 2008, most state legislatures also experienced striking increases in polarization, according to data assembled by McCarty and Boris Shor of the University of Chicago. If anything, over that period, most state legislatures polarized even more rapidly than Congress did.

Indeed, the polarization of our elected officials partially reflects the growing polarization of the public. We are increasingly surrounding ourselves physically and virtually with like-minded people, who then reinforce our biases and drive us further apart. In The Big Sort, for example, Bill Bishop documents increased residential segregation by political party. Over the past several decades, we have voluntarily separated ourselves into Republican and Democratic neighborhoods. Americans are also increasingly choosing to live near people in their own income bracket. Sean Reardon and Kendra Bischoff of Stanford University found that nearly two-thirds of American families lived in middle-income neighborhoods in 1970; by 2007, only 44 percent did. Since income is strongly related to voting patterns, this phenomenon may help explain the rise in residential segregation by political party.

The residential segregation by party, in turn, is reinforced by a splintered media market. Research suggests that Americans only tune in or log on to a small share of the media choices available to them, and they often pick the ones that fit their beliefs. The consequences are far-reaching. As Cass Sunstein emphasized in his book Going to Extremes, “When people talk to like-minded others, they tend to amplify their preexisting views, and to do so in a way that reduces their internal diversity.”

Governing in the Age of No Moderates

One obvious victim of this rise in polarization is the centrist legislating that has been the norm for most of postwar history. So what can be done? We can take on the problem on three different levels: encouraging less polarization in the population, increasing the number of moderates in Congress, and finding ways to govern effectively given a smaller number of moderates in Congress.

The first level involves dampening the degree of polarization in the population itself. To the extent that polarization is being driven by increased income inequality, one pathway to constraining it is to pursue policies (such as a more progressive tax code) that narrow after-tax income gaps. Another pathway is to highlight the importance of diversified interactions, both physically and virtually, to avoid the extremist tendencies that occur with self-reinforcing views. In speeches on college campuses, for example, I’ve been trying to communicate to students the importance of reading and listening to arguments from those with wildly different political views—because doing so will not only better inform their own thinking, but may also provide a broader social benefit by mitigating polarization. We should also remember that polarization has occurred in long waves in the past. Epochal shifts, such as world wars and the Great Depression, have brought Americans together and attenuated schism. It is possible, though not pleasant, to imagine similar catastrophic events that would offset the intensifying polarization among the public and in Congress.

The second level focuses on the gap between elites and the population. Whatever the degree of polarization in the population, what can be done to dampen the signal by the time it reaches Congress? Changes in districting laws could help, even if much more modestly than the punditry believes, to mitigate the loss of moderates in Congress compared to the underlying population. The greater degree of polarization in Congress than the population also suggests an opportunity: focus on electing moderates to Congress from districts where polarization is least severe. It is not in the interests of either party to do so, which means the effort would need to be driven primarily by non-party leaders, including from the business community. Indeed, efforts to elect centrist candidates such as Americans Elect would do much better to focus on Congress rather than trying in vain to elect a third-party candidate as president.

The third and final level addresses the problem of how to govern assuming a given level of polarization and a general absence of moderates in Congress. Within this category, two approaches suggest themselves. The default approach is for both parties to aim for partisan dominance and unified government, and then to legislate on a partisan basis. This partisan legislative approach represents an understandable and potentially effective response to polarization (at least from the perspective of legislative success). If you can’t govern in the middle, might as well govern, even if it is from one side.

Placing our bets on a partisan legislative model has substantial downsides, however. For one thing, political dominance across the White House, House of Representatives, and Senate is a relatively rare phenomenon, so the approach will often be frustrated in practice by some degree of divided government. Furthermore, even when political dominance occurs, the model represents a fundamental shift from the bipartisan norm that has dominated American policy-making during the postwar era. Finally, the model is inherently unstable, as the 1993 budget deal and the 2009 and 2010 stimulus and health-care examples suggest, since it is likely to create a backlash so strong as to eliminate the political dominance that allowed it. That backlash, in turn, risks making the underlying polarization even more extreme.

What to do during those periods of divided government (which is likely to be most of the time) with few moderates? As I have argued elsewhere, the best we can do to avoid gridlock may be to expand the degree of “automaticity” in the legislative process while retaining full congressional prerogatives to unwind such automaticity. For example, rather than requiring specific affirmative votes in Congress to extend stimulus measures, a better approach is to tie the stimulus measures to an objective indicator, like the share of the population working, and have those measures continue as long as the indicator (in this case, unemployment) is above a specified level. That way, the measures remain in effect as long as they are necessary, without the need for new legislation (though Congress can retain full authority to undo the measures at any time).

Similarly, even a divided Congress is often able to agree upon a process with uncertain outcomes, such as the creation of commissions tasked with finding solutions that take effect unless voted down by Congress. The base realignment and closure (BRAC) process provides a powerful example. It seems implausible that Congress would be able to agree upon which military bases to close through the normal legislative process. But through the BRAC process, first enacted in 1988, Congress delegates the job of choosing which excess military installations to close down to an independent commission, whose recommendations go into effect unless specifically voted down by Congress. The BRAC process—and others like it—works because it creates sufficient ambiguity about specific outcomes that objections are muted at the time of creation; the power of inertia then explains why the specific outcomes are allowed to take effect. For that second stage to work, it is essential that the proposals take effect automatically unless they are voted down by the Congress. This logic is reflected in the Independent Payment Advisory Board that was created as part of the health-care reform legislation to determine Medicare rates and rules.

Back to the Future, 2013 Version

So now back to our early 2013 hypothetical, in which we assume President Obama is re-elected and the House remains Republican. I say early 2013 on purpose, since I suspect the impediments to a deal will be more extreme during the lame-duck session at the end of 2012, before any of the tax expirations or sequestration cuts actually occur and while there may still be some maneuvering room to avoid the debt-limit bind. To the extent there is a serious attempt to get a deal done during the lame-duck session, the argument below still holds—albeit with a bit more force. (One factor that could change the dynamic substantially is if the debt limit turns out to be binding well before the end of the year—forcing a deal to occur in some form in 2012 rather than 2013.)

Given the overwhelming case for a major deal in early 2013, the difficulty of seeing how it could come together at this point only underscores the new political economy. It is not impossible to imagine, given the difficulty of passing bipartisan legislation and the distance between the Obama Administration and the House Republicans over tax policy in particular, that we will wind up with another “framework” agreement that leaves out specifics and delays decisions again, or alternatively a series of rolling temporary extensions of the debt limit and other provisions. That type of just-in-time governing would create unnecessary anxiety and uncertainty in an economy that is likely to remain weak relative to its potential.

In the grand negotiation to come (assuming that Obama and the House majority win re-election), supporters of the Obama Administration correctly note the leverage the Administration will have because all the tax cuts are scheduled to expire at the end of 2012. Note that if the middle-class tax cuts had been made permanent in 2010, this leverage would not exist, and the Administration would thus be facing another debt-limit dynamic similar to the one it faced in the summer of 2011. With the tax-cut expiration, by contrast, each side has leverage over the other—a fundamentally different dynamic, and one more likely to force both parties to the table. In other words, precisely because the Administration did not get what it wanted in 2010, the prospects for a significant deal in early 2013 are brighter—and that deal could well be broader in scope than anything that was possible in 2010. (In addition, the economy will have enjoyed some very modest benefit in the meantime from the meager additional stimulus provided by extending the high-income tax cuts for two years.)

The challenge is nonetheless that House Republicans will have to vote in favor of a debt-limit increase. The Administration’s success in pushing an extension of the payroll-tax holiday this past spring should not be seen as predictive of the 2013 mega-negotiation’s prospects, since the reason for that Administration win was that Republicans had somehow boxed themselves into a position—of appearing to oppose a tax cut—fundamentally contrary to their core views. In early 2013, by contrast, Republicans will again be fighting for tax relief—the ground they typically like to occupy.

One path through this brick wall for the Administration would be to allow all the tax cuts to expire and thereby escape the intractable debate over those extensions. In the cacophony that follows, the Administration could then come back in early 2013 with a tax-reform proposal that reduces taxes (compared to the level with the expired tax cuts) disproportionately for middle- and low-income families. If the tax cuts are designed to be universal, even if they are much more progressive than the Bush tax cuts, it would presumably be harder for Republicans to vote against them. One example of this strategy would be to combine a much larger payroll-tax holiday with an increase in the standard deduction. This would provide a substantial tax cut for everyone who works, but the effect would be progressive since payroll taxes represent a larger share of income for low- and middle-income workers than for high-income workers. As with the structure in place for the current payroll tax cut, general revenue would backfill the Social Security and Medicare Part A trust funds, so that the programs would not be harmed by the tax cut.

The problem with simply cutting payroll taxes is that it leaves out nonworkers, like the elderly. Therefore the second component of this proposal would raise the standard deduction, which is claimed by almost two-thirds of elderly filers. This component would also be progressive, since almost all high-income taxpayers itemize their deductions and therefore would not benefit from an increase in the standard deduction, and it would simplify the tax code by removing the need to itemize for more taxpayers.

By changing the discussion to a new tax proposal, it may be a bit easier to perpetuate a higher level of taxation on high-income families rather than continuing to debate the issue within the four corners of the Bush tax cuts. The tax cuts would be designed to avoid or minimize the fiscal contraction at the beginning of 2013, since the economy will remain too weak to handle a substantial fiscal tightening at that point. Ideally, however, even the middle- and lower-income tax cut within this strategy (the payroll tax holiday) would not be a permanent one, since over the medium term the federal government’s revenue base is inadequate for the tasks that have been assigned to it. So the significantly larger payroll-tax holiday could phase out as the labor market recovers. Middle- and lower-income families would be more severely affected by excessive reductions in existing government programs (like Medicare and Social Security) than a modest revenue increase to finance those programs.

That core tax package could be combined with other features. For example, we should reform the itemized deductions themselves. Many deductions are intended to promote socially beneficial activities, such as saving for retirement, purchasing health care, or owning a home. Yet with a deduction or exclusion approach, the tax benefit from spending $1 on one of these activities depends on the person’s marginal tax bracket. A person in the 15 percent marginal tax bracket who spends $1 on mortgage interest, for example, enjoys a 15-cent tax reduction from doing so; a person in the 35 percent marginal bracket enjoys a 35-cent tax cut for that same $1 in mortgage interest paid. This structure makes little sense from either a fairness or an efficiency perspective (as Lily Batchelder, Fred Goldberg, and I have argued in a Stanford Law Review article). A better approach would be to give each of these taxpayers, say, a 20-cent tax credit for each $1 in mortgage interest paid. Adopting this type of progressive approach to itemized deductions may require adding some less desirable policy—such as a second round of a corporate tax holiday on repatriated profits—to make the overall package legislatively feasible.

That broad approach may resolve the tax issue, albeit at the cost of some temporary turbulence, but it leaves open the debt limit and sequestration components of our early 2013 trifecta. Raising the debt limit and waiving the immediate spending cuts associated with sequestration will undoubtedly require entitlement changes. The question becomes whether the House Republicans accept the more modest entitlement changes discussed during the negotiations over the debt limit in 2011, or try to demand something more dramatic and problematic, such as block-granting Medicaid. The Administration would do well to aggressively combat the more radical proposals during the lame-duck session, lest it find itself boxed in unnecessarily in early 2013.

Before the critics start pointing out all the flaws in this strategy, it is worth emphasizing that none of the alternatives, including the one I sketch above, has an easy path to enactment. And that in turn underscores the key point: In a moderate-free Congress, it is much harder to govern—especially in a divided-government scenario. If nothing else, the likely drama later this year and early in 2013 will highlight the challenge of legislating in the new era of hyperpolarization.

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Peter Orszag is vice chairman of Global Banking at Citigroup. He previously served as the director of the Office of Management and Budget and as director of the Congressional Budget Office.

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