The fiscal Gordian knot

Here is the fiscal Gordian knot:

Congressional Republicans will only agree to sequester relief if offset by mandatory spending cuts, but President Obama and Congressional Democrats will only agree to mandatory spending cuts if taxes are also increased, and Republicans won’t raise taxes.

This fiscal Gordian knot caused the Super Committee to break down in late 2011. There was no agreement to replace the automatic discretionary spending cuts (aka the sequester) that President Obama proposed and signed into law in the Budget Control Act of 2011. He made a fundamental miscalculation when negotiating that law: he mistakenly assumed that Republican defense hawks would squawk so loudly at the disproportionate defense cuts imposed by the sequester that some Republicans would be willing to support tax increases in exchange for higher defense and non-defense discretionary spending.

The sequester replacement negotiations earlier this year were a second attempt by the President to untie the knot. That time he used political force, trying to bludgeon Republicans into agreeing to tax increases. Again he failed.

As the Republican demand to defund ObamaCare dissolved last week, the President and Leader Reid once again erred. Unsatisfied with a straight extension of current law spending and the debt limit and a political victory over Republicans, they increased their demands. They shifted from a sure-win defensive posture to an aggressive but risky offensive posture, demanding higher spending offset in part by tax increases.

House Budget Committee Chairman Ryan floated a sound and predictable Republican alternative: substituting mandatory spending cuts (specifically, changes to entitlement programs proposed by the President in his budget) to offset higher discretionary spending for defense and (I think) non-defense. This formed the core of Speaker Boehner’s recent offer to the President. The President rejected this offer because House Republicans were unwilling to also raise taxes. For a third time the President failed to untie the fiscal Gordian knot.

The negotiation now lies with Senate Leaders Reid and McConnell. (VP Biden, the only member of the President’s team with a proven track record of closing deals with Republicans, has apparently been locked away at Leader Reid’s insistence.) While the form of the Reid-McConnell negotiation is about the timing for when short-term extensions of the continuing resolution and the debt limit would next expire, the underlying substance of the negotiation is this fiscal Gordian knot. Both leaders are trying to structure both this negotiation and the next to maximize their leverage to achieve their respective fiscal goals.

Democrats had the advantage last week when they were playing defense, trying to block Republican demands to defund or delay parts of ObamaCare. The combination of the Cruz-Lee vaporware defund strategy, a House Republican conference unable to agree on anything, a Republican party message that was muddled at best, and an effective use of the bully pulpit by the President led to plummeting poll numbers for Congressional Republicans. Many Senate and some House Republicans seemed anxious to negotiate a deal that would temporarily both end the government shutdown and extend the debt limit deadline. With Leader McConnell’s tacit approval, Senator Collins kicked off the compromise attempt by initiating a rump group negotiation with a few Democrats. Leader Reid killed this fledgling bipartisan negotiation and once again took matters into his own hands, leading to the current discussion with his Republican counterpart.

Republicans now have a slight medium-term advantage for three reasons. I suspect that Democratic appropriators don’t feel as strongly about wanting to raise taxes as Congressional Republicans feel about not wanting to raise taxes. When they are eventually forced to choose, I’ll bet that enough Democrats (specifically, the appropriators) will accept entitlement spending cuts to fully offset higher discretionary spending, without any tax increases.

In addition, current law defaults to a position Republicans are more willing to accept than Democrats. Senators Cruz and Lee learned that he who favors current law has a significant tactical advantage in a shutdown fight. President Obama’s sequester in current law means the same is true on spending, but this time it favors fiscal conservatives.

Finally, when the public debate was “government shutdown vs. defunding ObamaCare,” Democrats had a communications advantage. Now the debate is shifting to “whether to bust the 2011 bipartisan budget deal by increasing spending and taxes.” That is right in the wheelhouse of today’s Republican party.

By insisting on tax increases to offset higher discretionary spending, Leader Reid and President Obama are doing what neither Boehner nor McConnell has been able to do for several weeks: unite Congressional Republicans. And Republicans have a strong counter: we will agree to higher discretionary spending as long as it’s offset only by entitlement spending cuts proposed by the President. I appreciate that many Democrats think it’s outrageous not to also raise taxes (and they’re nuts for thinking that), but that’s not the point. The key is that while most House and Senate Republicans felt forced into a shutdown over “defunding ObamaCare,” I’d bet that most of them will reject any Reid proposal to unravel the only bipartisan fiscal success of the past five years or to increase spending funded by higher taxes, even if such a rejection means that the government shutdown continues.

If Leader Reid and the President continue to insist on more spending and higher taxes, and especially if they want to try to enact it now, I think it backfires on them. They will reunite Congressional Republicans and give Republicans a much stronger rhetorical perch than they have had so far. Unfortunately, they would also continue the current stalemate.

(photo credit: Jay Allen)


I escaped Washington, DC and now teach at Stanford's Graduate School of Business.

Posted in budget
6 comments on “The fiscal Gordian knot
  1. Joe Aaron says:


    I started following you when you wrote a blog that said Bush was smarter than all the kids in your class. While I am not sure you are correct in that assertion, you make a good point. Bush gets criticized as being the dumbest in recent memory. I don’t think you make it through boarding school, Yale and HBS without being very capable. Bush did well with the opportunities presented to him.

    You wrote back you wanted to attract people like myself, Dems that would listen. But in this piece all you do is blame the Dems for wanting to raise taxes.

    Maybe we should raise taxes. I don’t think an R has voted for a tax increase since 41 was president, October of 1990. The purpose of that tax increase, as I recall, was to pay for the Gulf War. The last decade represents the first time in history that we did not raise taxes to pay for a war. Make that two wars. Not only did we not increase taxes during Bush 43’s tenure, we lowered them.

    Federal taxes as a percentage of the economy are at the lowest level since the Truman administration. Tax collections are the lowest level as a share of the economy in 60 years.

    Like everyone else, I don’t want my taxes to increase but we can’t sit by and do nothing. The young woman that serves big macs in Palo Alto pays about the same percentage of total taxes that Mitt Romney paid at 14%. That is just not right.

    What am I missing?


    Joe Aaron
    Sonoma, CA

  2. Robert Ferguson says:

    Does the 14% for Romney include income from investments? If so, weren’t the investments net of tax?

    • Joe Aaron says:

      Almost all of Romney’s income was carried interest or long term capital gains derived from his general partner’s interest in Bain’s deals. He had no ordinary income. That is the reason his effective tax rate was so low. I know because I had the exact same benefit as a hedge fund manager. That is probably the reason he only release three years returns. Everyone does ten. I assume Romney’s effective tax rate was lower in those other seven years which would have made it harder to get elected.

  3. ‘Federal taxes as a percentage of the economy are at the lowest level since the Truman administration.’

    But not because of any changes to tax laws by the Bush Administration. Before the recession of 2008 tax revenues were slightly higher than the average of the past six decades. That revenues haven’t rebounded is due to the anemic economic recovery (on Obama’s watch).

  4. Kevin Brock says:

    It is past time to end the wage earner penalty, and treat all income from all sources equally in the eyes of the tax man. It is past time to end the taxpayer subsidies for Wal-Mart, fast food chains, and all other low-wage employers, whose employees must depend on Medicaid and SNAP and other government assistance in order to survive. In short, it is time to end the three-decade long experiment in supply-side fiscal and regulatory policies, that have resulted in the greatest concentration of wealth in the hands of the few since the Gilded Age.

    • Joe Aaron says:

      Have I found a brother? If so let me express my views on our susidizing the public shareholder.

      Seventy five years ago, President Franklin D. Roosevelt signed the Fair Labor Standards Act. Among other things it outlawed child labor and guaranteed a minimum wage. This capped the official workweek at 40 hours forcing employers to hire more people or pay overtime to exhausted employees.

      Governor Jerry Brown just signed into law a bill that will increase the state’s minimum wage to $10 per hour in 2016.

      McDonalds, Burger King, Wal-Mart, Target, you name them; have been making huge profits for their shareholders by paying their employees sub-poverty level wages. As a result, you and the other 53% of taxpayers are paying Medicaid, food stamps, child care and subsidized housing for their employees.
      The fact is employers pay their work force as much as they are forced to and no more. There’s no compelling reason to give raises.

      The Federal Government requires you to pay a full time employee benefits. Generally, any job requiring over 30 hours a week constitutes full employment.

      Long ago the Big Dogs figured out how to get around this feeble attempt to make them pay their fair share. Take any big box store with 100 full time employees working 30 hours a week. They simply reduce your hours from 30 hours to 20. Under 30 hours makes you a “temp” who by definition is not entitled to benefits. By hiring another 50 temps they lower their labor costs and increase their corporate earnings. Shareholders rejoice!

      Here is another secret the Big Dogs don’t want you to know. Big companies including the obesity enablers
      McDonald’s, KFC, Denny’s and Coke, have long relied on software to determine the precise number of workers needed on any given day based upon the weather. Sun, rain or snow the software tells you how many workers you will need that day. Don’t bother calling. You can tell them when they show up for work.
      The Federal minimum wage is $7.25/. Here in California it is $8.00. Assume a worker has learned to game the system to juggle his 20 hours at Jack-in-the-Box with the 20 he gets at Denny’s. The math is not pretty. That is $14,500 a year, $16,000 in California. If both Mom and Dad can pull off 40 hours a week they will make $32,000.

      How do you feed and cloth a family of four, much less save for retirement, on $32,000 a year?

      The Federal Government defines poverty as a family of four living on $24,000 per year. This metric applies nationwide; Hoboken or Eureka. There is not a lot of room at that level of income to buy Ho Ho’s or Ding Dongs, even with food stamps. You can’t pay for the gas in a car much less save to buy one. You take public transportation to get to and from work, pick up your kids and to the grocery store.
      I dare say not 1% of the readers of this missive have any idea what hardships these people endure. I know I don’t. I was born a white male in the US in the 20th century, to nurturing and loving parents. I won the lottery.
      I don’t know about you but I don’t envy that poor person’s easy life sucking off my tax dollar. Is there any question why these people must look to the state and federal Government for help?
      For healthcare coverage a family of four would need to pay Blue Shield of California about $6000 a year. Don’t forget there is a $5,000 deductible. That $6,000 in premium is almost 20% of that family’s gross income. This is on top of the 9% they pay into Social Security. As I recall Mitt Romney paid 14% of his gross income in taxes. This family is already at 29%.

      What about child care? We taxpayers foot that bill too. Two kids can get childcare at $6 an hour. That is $12,000 annually. This subsidy is usually paid for by the individual state and is based upon income.

      Almost 40 million people receive federal food stamps. A family of four qualifies for $668 a month at the poverty level of $24,000. That is about $5.50 a day which may get you a Happy Meal as long as you don’t Super Size it.

      It is estimated every Wal-Mart employee costs the federal taxpayer $1,000 in annual benefits. Wal-Mart employees 12,300 people in Florida who are eligible for Medicaid. Let’s hope it is an urban legend that Wal-Mart tutors their employees on how to qualify for food stamps.

      My complaint is big publicly traded companies are not paying a livable wage. These corporate welfare cheats have had us subsidizing their shareholders for years. It is time they paid their fair share. It is time we insisted there be no temps when the purpose is to avoid paying benefits. It is time to raise the minimum wage to a livable wage.

      Costco is a shining example of what a responsible corporate citizen looks like. They pay their employees, nationwide, a minimum of $16 per hour. Their employees are in the top 50% of wage earners in the US.

      Could Costco pay the minimum wage? Yes. Could McDonalds pay their employees $16 an hour? Indeed. To cover the added cost your Big Mac would go from $4.00 to $4.10 according to Wall Street analysts. Hardly material.

      Does the $16 an hour wage lower the profits for the Costco shareholder? Yes, yet their stock is up over 100% since July of 2010? Do you and I pay for healthcare, childcare, food stamps and subsidized housing for Costco employees? No.

      This fall you should vote in your own financial interest. Vote for the financial interest of your fellow Americans. Vote for candidates who want to increase the minimum wage and stop subsidizing shareholders.

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