A New Route Around the Fiscal Cliff

The fiscal cliff represents an opportunity as well as a danger. While a big tax increase might provoke a double-dip recession, even the complete repeal of the Bush tax cuts are only a down-payment in a long-term plan for fiscal balance.

A "grand bargain" should take both the short and long term into account. It should explicitly tie tax hikes and spending cuts to economic conditions. Belt-tightening might begin, say, when unemployment declines from present levels to seven percent -- with top rates moving from the current 35 percent to 37 percent, and a third of the spending cuts realized at the same time. There would only be a return to the top Clinton-era rate of 39.6 percent, along with full spending cuts, when the economy returns to healthy conditions generally associated with a 6 percent rate of unemployment.

Curing our long term fiscal problems is hard enough without punishing our weak economy in the short run. As Keynes emphasized, "The boom, not the slump, is the right time for austerity." Following this maxim, the grand bargain should contain special belt-tightening provisions that raise taxes above Clinton era rates if unemployment falls significantly below the 6 percent mark. Boom-time austerity would represent a further payment on our long-term national debt to offset unexpectedly severe declines in the business cycle.

When the next recession hits, tax rates should go back down on the same schedule they went up. Instead of relying on Congress to provide appropriate stimulus packages and, even more unlikely, respond to booms with austerity, a statutory linkage separates fiscal stabilization policy from the vagaries of the political process.

This reform will make long-term budget politics more transparent. At present, both Republicans and Democrats can disguise their long term political goals as short term stimulus measures. During periods of economic weakness, they claim that their favorite tax cuts or public investments will give the economy a much-needed boost -- confident that these "temporary" measures will entrench themselves as permanent fixtures. Once stabilization policy is designed into the very structure of the grand bargain, this bait-and-switch gambit will be far less plausible. Since rates and spending levels are moving up and down automatically, both sides will be obliged to defend new initiatives on their long-term merits.

An explicit link to the business cycle also creates a new stabilization mechanism for the economy. Since people will know that taxes will be lower in recessions and higher in booms, they have new incentives to adjust their economic activity counter-cyclically -- working and investing more when taxes are low, and less when they are high. At the same time, automatic stabilization will preserve the nation's rock-solid credit rating by avoiding an endless series of cliff-hangers.

There are risks, as well as rewards, to our strategy. If the grand bargain misjudges the "full employment" rate, taxes and spending may rise too soon or too late -- cooling off or overheating the economy at inappropriate moments. But the Federal Reserve is already making guesses at the "full employment" rate when setting monetary policy. While it makes mistakes, its overall track record is pretty good. What is more, Congress and the President can fine-tune the triggering formulas as they learn from their mistakes. Other measures of economic health, such as GDP growth or labor force participation rates, can be used to supplement reliance on the unemployment rate. This process of structured learning is far superior to the present pattern of ad hoc response that generates artificial crises that shake confidence in the nation's political leadership.

Our linkage proposal is currently off the radar screen. But in the 1960s and 1970s, leading economists from places like Harvard and Brookings put the case for reform at the center of policy debate. While their initiative ultimately went nowhere, perhaps we'll be wiser this time around?

The writers are both professors at Yale Law School.