Congress Needs to Add Deficit Reduction to Its Priority List

A bipartisan plan to end the wasteful Employee Retention Credit program will save $70 billion. Why are lawmakers planning to spend the money on new goodies?

Dear readers,

Somewhat surprisingly, despite all the outward dysfunction, there are three major bipartisan deals — meaty, substantive policy initiatives — with serious chances of getting through Congress in the coming weeks or months.

The first, and least surprising, is a spending agreement for the current fiscal year. This is necessary to keep the government open, and the top-line spending terms were already set in last year’s Fiscal Responsibility Act, so it is a “must-pass” item that will happen sooner or later, despite the tantrums of the Freedom Caucus. The second is a supplemental spending bill to address the migration crisis and provide aid to Israel and Ukraine — congressional leaders were at the White House to discuss this initiative on Wednesday and they sounded a little more positive than they have in recent weeks about the possibility of agreement, even though the parties remain very far apart on the migration issues; the deal might still fall apart. The third is a tax reform proposal from Democratic Sen. Ron Wyden and Republican Rep. Jason Smith, the leaders of the tax-writing committees in each chamber of Congress, which combines Republican priorities (tax credits to encourage business investment) with Democratic priorities (increasing the child tax credit, especially for lower-income families).

There is something I find a little odd about the stacking of these three deals. The tax reform deal — the one that is farthest from being a “must-pass” item — is designed to avoid increasing the budget deficit. To offset a few years of more generous tax credits for businesses and families, the tax-writing lawmakers hope to save about $70 billion by shortening the deadline to claim benefits under a pandemic-era aid program, the Employee Retention Credit, while increasing the penalties that can be assessed on tax preparers who help businesses make false claims under the program. This reflects a bipartisan consensus that the ERC program has become rife with fraud, with crooked tax preparers inducing small businesses to make claims they don’t necessarily even know are fraudulent. Besides, the acute pandemic is over, and we don’t need this program anymore — throwing more money at businesses today on the basis of their payroll expenses in 2020 and 2021 doesn’t actually do anything to create jobs or improve the economy right now.

So that last part is all well and good — I support the bipartisan initiative to kill the fraud-ridden ERC and save $70 billion. But why should the savings be used to finance both parties’ nice-to-have tax policy agenda items?

We are currently running a federal budget deficit of nearly 6% of GDP. Such a large deficit can be very justified when the economy is slack and interest rates are low — at those times, the government can borrow cheaply and use the proceeds to stimulate the economy. But in current conditions, those large deficits are just keeping interest rates high and crowding out private investment. We need to shrink the deficit, and while cutting “waste, fraud and abuse” is never going to be enough to fix the federal budget, it is a good place to start. If the government finds $70 billion it was poised to flush down a toilet, it should save that money, not come up with something else to spend it on.

The best argument I’ve seen for the tax deal as structured comes from George Callas, a former Republican staffer on the House Ways and Means Committee who now runs public finance initiatives at Arnold Ventures, the centrist philanthropy run by Laura and John Arnold. He notes that ERC reform is a wasting asset: if lawmakers don’t act, the government will gradually send out that $70 billion, much of it to scammers. And I agree that if the alternative to the Wyden-Smith tax deal is doing nothing, we should do the tax deal. But if those are the only available options, that’s a reflection of how our new interest-rate reality has not set in for Congress: neither Republicans nor Democrats are focused on the harm that high deficits and high interest rates do to the economy, and so it’s not even possible to imagine a bipartisan agreement that simply kills the ERC and pockets the savings for deficit reduction.

Then, of course, there is the issue of the spending supplemental for Israel, Ukraine and the border. The version of this that the White House has proposed would cost $106 billion and also includes line items for humanitarian aid and countering Chinese influence around the world. $106 billion is not a trivial amount of spending — it’s nearly 0.5% of GDP — and for the last couple of decades, Congress has tended to pass these supplemental spending bills without offsetting their cost. The idea is that supplementals are for emergencies, so they’re really important; and the spending they contain is temporary, so it need not be offset with permanent revenue sources or spending reductions. (Of course, some of the major uses of supplemental spending since the year 2000, like the Iraq War, ended up being less temporary than hoped and were a major driver of the long rise in our debt/GDP ratio.)

Some congressional Republicans, wary of aiding Ukraine and upset about ballooning spending, have urged that the spending in the supplemental bill be offset. Could the $70 billion of available savings from killing ERC perhaps be useful as a part of this legislative negotiation, helping Congress get to “yes” on a deal to aid Ukraine and address immigration without nearly so large an impact on the deficit? This pairing actually has better budgetary logic: the $70 billion is a one-time savings and the spending on these acute crises is (hopefully) (possibly) also a one-time deal, while Democrats and Republicans would hope to extend the tax provisions in Wyden-Smith indefinitely.

Dall-E image generation for “fiscal space”

But ultimately, this is a question of priorities. I have implicitly laid my cards on the table: I think helping Ukraine oppose Russian aggression is more important than increasing the child tax credit, and I think reducing illegal entry and processing asylum claims faster is more important than giving businesses larger tax incentives for research and development. My rank-order priority list for how I would use available fiscal space goes something like this: Ukraine aid, opposing China, migration-related spending, deficit reduction, business investment tax credits, child tax credit enhancement, humanitarian aid, Israel aid¹. And the biggest reason I have a negative view on the Wyden-Smith tax deal is it doesn’t comport with my rank-order priority list: there are many projects, including deficit reduction, that I’d sooner fund with $70 billion of fiscal “space” from killing the ERC.

Unfortunately, Congress does not seem to be in a priority-setting headspace yet. These deals all operate on separate tracks, and there’s no apparent sense that Ukraine aid and the child tax credit are two different priorities both competing for the same amount of fiscal space. Nor is Congress seriously considering big moves to create more fiscal space.² We see small deals that tinker at the margin with discretionary spending, but there has not yet been an effort to find bipartisan compromise on persistent, deficit-reducing changes to our tax code and to entitlement spending programs — even though such changes would create more space for important discretionary programs and make it easier for businesses to invest by taking upward pressure off interest rates. And unfortunately, I think it’s going to take a few more years of consumer frustration over high mortgage rates before that prioritization mindset sets in.

I’ll be back on Saturday with a Wegovy update and some thoughts on how this presidential campaign manages to be so uninteresting while also being important.

Very seriously,

Josh

1. Unlike Ukraine, Israel is a high-income country fighting a power that is militarily much weaker than itself, so it’s not clear to me why Israel needs our financial support to fight its war. Also, given the way the Israeli government keeps giving the Biden administration the finger, it does not appear that financial aid to Israel has served the purpose of buying us influence with its government. That said, as a political matter, I understand that Israel aid will be rolled into any Ukraine package, whatever my own preferences and priorities are.

2. Here is one idea: If it’s a good idea to enhance the pro-investment credits offered in our corporate tax code, perhaps that could be financed by raising the corporate income tax rate? The key conceit behind the 2017 Tax Cuts and Jobs Act, which cut the corporate income tax rate from 35% to 21%, was that both our corporate and individual income tax systems offered too many deductions and credits, and that curtailing those deductions and credits would partly offset the revenue loss from tax rate cuts. If legislators have now decided it was a mistake to slash those credits so much, then the rationale for cutting rates so much has been undermined, and a tax rate increase seems like a natural place to look for fiscal space to fix that mistake.