This is the third of three posts on the Budget Control Act.

The other two posts are:

1. Quick summary of the Budget Control Act; and
2. Understanding the Budget Control Act.

I cover three topics in this post: what important players won in this deal, the core concepts and tradeoffs within the deal, and what the different strategies might be this Fall under this bill if (when?) it becomes law.

The President’s priorities

The President knows he will get debt limit increases through early 2013 no matter what House conservatives/Tea Party members do. Those Members can no longer “hold a debt limit increase hostage” before the 2012 election.

We could also describe this as eliminating liquidity risk through 2012.

Assuming someone doesn’t find a way out of the enforcement mechanisms in the bill (1 in 3 chance), there will be at least $2.1 T in deficit reduction over the next 10 years as a result. While I think that’s a big policy benefit, I’m not sure how important that is substantively to the President. (Is he for stimulus? Austerity? Who knows at this point.)

But given his recent public conversion to deficit hawk, the President will undoubtedly stress it publicly over the next 18 months and began doing so last night. At a minimum, the President will benefit politically with deficit hawk centrists, both for the policy result and the achievement of a bipartisan agreement. Prepare to watch the President seize political credit for spending cuts he fought.

The President also has an opportunity to push for tax increases as part of the Joint Committee deficit reduction process this fall. You will hear the corporate jets & Big Oil riffs ad nauseam.

Republican / conservative / Tea Party priorities

The Speaker set a goal for House Republicans of at least a dollar of spending cuts for each dollar of debt limit increase. This law guarantees at least a dollar of deficit reduction for each dollar of debt limit increase. Thus this law guarantees at least $2.1 T in deficit reduction over the next 10 years. That’s not $4 T but it’s not bad in a balanced Washington.

Of that deficit reduction, at least $917 B of it is from spending cuts and discretionary spending caps, and House Republicans can guarantee that it all comes from spending cuts and caps if they are willing to threaten to cut defense a lot (which is different than actually cutting defense a lot). Through this law Republicans have the opportunity to lock in at least $2.1 T in spending cuts over the next 10 years. The spending caps will be in law and enforced with a sequester, meaning they are not gimmicks. Yes, a future Congress can change the law and undo those caps, but the same is true for any policy change.

While the Joint Committee process does not preclude tax increases cuts, it is tilted pretty heavily against them and toward spending cuts. That is huge.

The tax rate and cap gains & dividends fights probably shift to outside this Joint Committee process. I expect a recurrence of the 2010 fight in 2012, this time with the President threatening a veto. The use of a current law baseline for revenues in this fight is a rhetorical but not a procedural concession. My money remains on another extension of current rates and no tax rate increases in 2013. The underlying political pressures are unchanged.

The Balanced Budget Act will get a vote this fall in the Senate, and there is a modest financial incentive (a higher debt limit increase) for the Senate to pass it. I still think it’s unlikely this will be sent to the States, but this is a process improvement relative to where they are now on a BBA.

Congressional Democrats’ priorities

In addition to the goals listed above for the President, Senate Democrats get to punt this year and next on passing a budget resolution and making any politically difficult choices in the open. This is for me the only unequivocally bad part of this bill. It is process abuse, in which Senate Democrats are avoiding taking responsibility for proposing solutions to America’s biggest economic policy problems.

Core concepts & tradeoffs

• The President avoids another debt limit battle before his election. (Hey, he framed it this way.)
• Republicans get >$2T of deficit reduction and the ability to block tax increases and force spending cuts.
• This fall Democrats will face a hard choice: cut the big entitlements or cut domestic discretionary spending even further?
• This fall Republicans will face a hard decision: are you willing to taking the chance that defense discretionary will be cut even more deeply to avoid tax increases?

The new trigger mechanism is the key to this new deal and the fall battle.  The trigger makes tax increases quite difficult (should make Rs happy), provides no benefit to raising tax rates (Rs even happier) but doesn’t rule out targeted tax increases (should minimally satisfy Ds). The trigger cuts defense spending more deeply than nondefense spending, in theory creating greater pressure on Republicans than on Democrats to want the Joint Committee process to succeed.

I think Team Obama thinks, because a failed Joint Committee would cause the trigger to cut defense spending an additional 10% and nondefense discretionary spending “only” an additional 8%, that Republicans will pay anything to get a new law, including agreeing to tax increases. I think Congressional Republicans think this judgment is wrong, and this difference of opinion allows both sides to agree to this trigger and this new law.

The President’s strategy for the fall Joint Committee battle

The President is telegraphing his strategy. He will threaten to oppose (veto?) any product of the Joint Committee that does not raise taxes on his favorite targets (“balance”). In doing so, he will be threatening something valuable to most Republicans: defense spending. While last spring Tea Party conservatives took a debt limit increase hostage to force Democrats to cut spending, this fall the President will take national security spending hostage to (try to) force Republicans to raise taxes on politically unpopular constituencies.

A Republican counter-strategy

There is a simple Republican counter strategy available:

• Speaker Boehner and Leader McConnell appoint to the Joint Committee six Members who will not raise taxes.
• These six Republicans call the President’s bluff, and tell their Democratic counterparts they are willing to reject a deal that includes tax increases, even if that deal means the trigger will cut defense deeply. They deny the six Democratic Members of the Committee negotiating leverage from the difference between a triggered 10% cut in defense and an 8% cut in nondefense discretionary spending. “This is going to hurt you almost as much as it’s going to hurt me, so I’m not giving you anything to avoid it.”
• These six Republicans encourage everyone to cooperate to get most (all?) of the $1.5 T in deficit reduction from the Big 3 entitlement programs: Social Security, Medicare, and Medicaid. They are the cause of our long-term fiscal problems and they are so big and growing so rapidly that you can save lots by changing them.

I am reminded of the familiar scene in an action movie. The bad guy holds a hostage and a hand grenade while our hero, five feet away, points a gun at the bad guy. The bad guy threatens to pull the grenade pin and kill himself, the hostage, and our hero. He points out that the hero may not care about himself, but surely he doesn’t want to risk the life of this innocent young girl.

The hero, who we know is a kind and compassionate man, looks the bad guy straight in the eye and says, “Go ahead. Blow us all up. I don’t care about her, and I don’t care about myself, as long as you’re killed in the process as well. We both know you won’t pull that pin because you won’t kill yourself. So let her go and let’s end this peacefully.” The bad guy backs down because the hero has demonstrated the threat provides no relative advantage. As long as the exploding grenade would do sufficient damage to the bad guy (death), it doesn’t matter that the hero suffers a greater loss (death X 2). The bad guy doesn’t want to carry through with his threat any more than the hero does.

(I am not suggesting the President is a bad guy with a grenade.  It is just a metaphor to illustrate a negotiating concept.)

The same is true here. An additional 10% cut to defense discretionary is deep, and many Republicans will intensely want to avoid it. At the same time, an additional 8% cut in nondefense discretionary will freak out many Congressional Democrats and the White House, and they will intensely want to avoid it. I think the depth of both cuts are so deep, and the difference between -10% and -8% is small enough, that it confers no relative advantage in the Joint Committee. Democratic negotiators will be just as desperate to avoid 8% domestic discretionary cuts as Republicans will be to avoid 10% defense cuts.

This means that all Republicans need to do is call the President’s/Democrats’ bluff on tax increases, threaten to allow the pain of the trigger hit both sides, offer $1.5 T of entitlement spending cuts, and wait.

$2 trillion of spending cuts is big for Congress but small relative to our underlying fiscal problems. If this bill becomes law and if the fall Joint Committee process is successful, the remaining spending problem will be more than an order of magnitude larger than this accomplishment. If you think this summer has been painful or dread the battle of this fall, you ain’t seen nothin’ yet. Wait until Congress wrestles with the big stuff.

Three times in the past year Congressional Republicans have played brinksmanship with the President and come out ahead:  the December 2010 tax rate fight, the Spring 2011 CR fight, and now the Summer 2011 debt limit fight. They have a game plan that has delivered multiple incremental wins so far, and a playing field that favors them for the Fall 2011 Joint Committee fight. In a balanced Washington they have successfully leveraged a debt limit increase to cut spending and not raise taxes.

For these reasons I am fairly optimistic this bill provides an opportunity for another incremental win this fall. If I’m right, it also establishes a pattern for when the debt limit expires in 2013.

(photo credit: Andrew Magill)

This is the second of three posts on the bill agreed to by the President and the bipartisan bicameral leaders of Congress (Speaker Boehner and Leaders Reid, McConnell, and Pelosi).

The other two posts are:

1. Quick summary of the Budget Control Act; and
2. Strategic analysis of the Budget Control Act.

If you have not read my quick summary post, please do so before reading this one. I cover three topics in this post:  how taxes are treated in the Joint Committee, how the spending cut trigger works, and the intentional imbalance of triggered spending cuts.  All three are critical to the strategic analysis.

How taxes are treated in the Joint Committee

This bill does not raise taxes.

The $917 B of spending cuts that immediately take effect are just that, spending cuts. No tax increases there.

The Balanced Budget Amendment might or might not have a 2/3 voting requirement to raise taxes. That’s up to the House and Senate to decide when they vote on a BBA.

It gets complex when you look at the new Joint Committee. I think it’s easier if I break it into four questions:

1. If the Joint Committee process fails, could the automatic sequester mechanism raise taxes?
2. Is the Joint Committee allowed to raise taxes?
3. Can the Joint Committee count tax increases toward hitting its deficit reduction target?
4. What does the bill do to efforts to raise taxes outside of this process?

As I read the bill text, the answers are:

1. No.  The automatic triggered sequester cuts spending. It cannot raise taxes.
2. Yes, the Joint Committee is allowed to raise taxes. Nothing forbids the Committee from including any tax increase they like, if they have 7 or more votes to do so. But to become law that bill would also need the support of a majority of the House.
3. No for any taxes already scheduled to increase in the next 10 years under current law (e.g., the Bush-Obama tax rates, AMT, or any expiring tax extenders). Yes for any other proposed tax increase (e.g., corporate jets, Big Oil, carried interest, LIFO, capping itemized deductions for high income tax filers, or any other “new” tax increase). See below for more details.
4. The bill creates a 60 vote Senate budget point of order against legislation that would extend any of the Bush-Obama tax rates or patch the Alternative Minimum Tax. Then again, those bills already face a 60 vote filibuster threshold, and last year such a point of order existed against extending the top tax rates, so practically speaking, this isn’t a new or higher hurdle.

Details on #2 and #3

The Joint Committee can choose to raise taxes if a majority of the 12 members agree. This would require at least one of Speaker Boehner’s three or Leader McConnell’s three appointees to agree to raise taxes. The more important question is: would such tax increases count toward the Committee’s $1.5 T deficit reduction target?

The key technical detail is that the Committee’s recommendations on taxes will be measured against a current law baseline for taxes. Under current law, certain taxes are scheduled to go up in 2013, most notably the individual income tax rates and rates on capital gains and dividends. Normally Republicans dislike a current law baseline on taxes, but in this case it helps them.

Here’s what that means for the Joint Committee:

• If the Committee allows tax rates to increase in 2013 (aka “raise tax rates in 2013,” or “let the Bush-Obama tax cuts expire,” depending on your point of view), the additional revenues raised will not count toward the Joint Committee’s target since this is already current law. So raising these tax rates doesn’t help the Committee meet their $1.5 T deficit target.  That doesn’t mean they can’t include them in their legislation (they can), just that they can’t get any numeric benefit for doing so. That is incredibly important.
• The same is true for capital gains and dividends. While a majority of the Committee could agree to allow those rates to increase, they won’t get any numeric benefit from doing so (unless they were to go above the 20% scheduled for current law starting in 2013).
• The same would be true for the alternative minimum tax. If the Committee were to decide to let the AMT bite a lot more people, they wouldn’t be scored with any additional revenues raised to meet their deficit reduction target, since that is already scheduled to happen under current law.
• The same would be true for any tax extender-like provisions scheduled to expire under current law (e.g., the ethanol tax credit).  Allowing them to expire (or scaling them back) won’t get scored as deficit reduction for the Joint Committee because they are already scheduled to expire under current law. It won’t move them any closer to their goal.
• But other “new” tax increases would count toward the Joint Committee’s deficit reduction target.  If the Committee eliminates depreciation for corporate jets, for instance, or or repeals or scales back carried interest or LIFO, or caps itemized deductions for high-income tax filers, those would score as tax increases relative to current law, and the Committee would get credit for deficit reduction for including those tax increases.

Therefore, if the six committee Democrats can convince one of the Republicans to raise taxes, they have an incentive to raise new taxes rather than tax rates on income, capital gains, or dividends. The tax rate fights are most likely to occur outside this process.

In any case, if 218 House Republicans don’t want to raise taxes, they can kill the Joint Committee’s recommendations, triggering the automatic spending cuts. There is, however, a downside to that for Republicans …

How the spending cut trigger works

First, it’s a spending cut trigger. It does not and cannot trigger any tax increases.

Second, the trigger kicks in only if the Joint Committee process fails to result in a new law enacting deficit reduction of at least $1.2 T over the next 10 years.

The trigger would cut spending by ($1.2 T minus the amount of deficit reduction enacted into law through the Joint Committee process).

The trigger would cut all discretionary spending, Medicare, farm subsidies, mandatory housing subsidies, and a few smaller mandatory spending programs. Social Security, veterans’ benefits, civilian and military retirement, and all low-income subsidies including Medicaid and the “welfare” programs (food stamps, SSI, etc.) would be exempt from the trigger. Net Interest payments would also be exempt.

The spending cuts are split evenly (measured in dollars) between two pots:

1. defense discretionary;
2. nondefense discretionary + covered entitlements.

As in the 1997 budget law, the cut to Medicare is capped at 2%.

The imbalance of triggered spending cuts

If the Committee fails altogether or comes up short of its $1.2 T deficit reduction target, the triggered spending cuts kick in. The automatically triggered spending cuts are designed to cut defense discretionary spending by a greater percentage than nondefense discretionary spending.  Since the dollar amount of the cuts are allocated 50/50, and the nondefense discretionary spending also has Medicare and about $50 B of other annual entitlement spending in its base, the cuts to nondefense discretionary spending are diluted by the cuts to the included entitlements.

Example:  Suppose the Joint Committee process fails completely and no law enacts new deficit reduction this fall. Just s’pose.

The trigger then must cut spending by $1.2 T over ten (actually, nine) years.  Here are the mechanics of how those spending cuts are allocated.

• First back out interest savings (18% of the total, or $216 B). That leaves $984 B of spending cuts.
• Spread that out evenly over nine years. That means cut spending by $109 B per year for each of FY13 – FY21.
• Split that $109 B evenly between (defense) and (nondefense + some mandatory). So each category takes about a $55 B hit in each of the next nine years.
• That would result in about a $54 B cut in defense discretionary spending in FY13.
• The other $55 B in spending cuts gets applied to (nondefense discretionary + Medicare + some other entitlements). But the cut to Medicare is capped at 2%.
• The result of this is that nondefense discretionary and these other entitlements would take about an 8% cut.

Therefore:

• Defense discretionary spending would be $546 B if the Committee hits its target, and about $492 B if the Committee fails entirely. That’s 10% less, a $54 B cut in defense discretionary spending in 2013.
• Nondefense discretionary spending would be $501 B if the Committee hits its target, and about $461 B if the Committee fails entirely. That’s 8% less, a $40 B cut in nondefense discretionary spending in 2013.
• Medicare spending would be cut 2% in 2013.
• Farm programs and a few other entitlements would be cut 8% in 2013.

Note that in both cases, the discretionary percentage cuts are on top of the 2013 share of the $917 B of discretionary spending cuts enacted when the Budget Control Act is signed.  Discretionary spenders will correctly argue that they are paying once up front to offset the initial $900 B debt limit increases, and then again to offset almost all of the $1.2 T debt limit increase if the Joint Committee process fails.

A key strategic point is the relative pain applied to the two parties’ spending priorities. In this example where the Joint Committee process fails, defense takes a 10% cut on top of its share of the initial $917 B cut, while nondefense takes an additional 8% cut and Medicare takes a 2% cut.

This imbalance is intentional and was key to reaching agreement on the Budget Control Act.  It’s also critical to how the Joint Committee might work.

To understand why, please see Strategic analysis of the Budget Control Act, the last post in this series.

(photo credit: David Beyer)

This is the first of three posts on the bill agreed to by the President and the bipartisan bicameral leaders of Congress (Speaker Boehner, and Leaders Reid, McConnell, and Pelosi). The bill is called the Budget Control Act of 2011.

The two other posts are:

1. Understanding the Budget Control Act; and
2. Strategic analysis of the Budget Control Act.

The “understanding” post covers in some detail a few critical details for insiders and experts. The strategic analysis post tries examine how this deal came together and what might result from it this fall.

Preliminary sources:

• bill text;
• Speaker Boehner’s slides used with the House Republican conference;
• the President’s statement from Sunday night; and
• the White House fact sheet describing the bill from their perspective.

Everything below assumes the new Budget Control Act of 2011 bill passes the House and Senate and is signed into law by the President.

I’m going to try to be neutral in this description and put my analysis in a separate post.

Debt limit

• The debt limit will be increased by $2.1 T no matter what Congress does.
• The debt limit can be increased up to an additional $300 B depending on what Congress does on deficit reduction and a Balanced Budget Amendment (BBA).
• The debt limit increase will happen in three steps: $400 B immediately, then +$500 B, then the remainder after Congress tries to enact further deficit reduction and pass a BBA.
• Assuming the economy doesn’t go into the tank, this should eliminate the risk of another cash flow crisis for about 18 months, into early 2013. (No, it was never a “default” crisis.)

Spending cuts, tax increases, and deficit reduction

• Whether or not Congress successfully enacts another deficit reduction law in the fall, the total deficit reduction will exceed the debt limit increase available to the President. If Congress fails this fall, some of that deficit reduction will happen through automatically triggered spending cuts.
• As soon as the Budget Control Act becomes law, discretionary spending (aka annual appropriations) will be cut and capped, with projected savings of $917 B over 10 years, more than the initial $900 B of debt limit increase allowed the President. This is measured relative to a traditional inflation baseline for discretionary spending, without using the “Iraq/Afghanistan war baseline gimmick.”
• In addition to these immediately enacted spending cuts from the cut and spending caps, a complex process will lead to additional deficit reduction of $1.2 – $1.5 T (or in theory more) over the next 10 years. That additional deficit reduction will result either from a new law enacted by the end of 2011, or from automatically triggered spending cuts written into the Budget Control Act (or from a combination of the two). The last leg of the President’s debt limit increase is tied to this additional deficit reduction.
• How that additional deficit reduction is achieved is uncertain:
  • The bill creates a new Joint Committee of 12 Members of Congress (6 R, 6 D), whose goal is to produce a bill that would reduce the deficit by $1.5 T over 10 years. If 7 or more Members of that Committee approve a bill by November 23rd, it is guaranteed a straight up-or-down vote in the House and Senate by December 23rd.  No amendments and no Senate filibuster are allowed of this bill. It’s take-it-or-leave-it to everyone.
  • If this new Joint Committee legislative process fails to result in a law, then there will be no tax increases and there will be triggered $1.2 T of across-the-board spending cuts in discretionary spending, Medicare, farm subsidies, and a few smaller entitlements. These triggered spending cuts would hit defense more deeply than other types of spending.
  • The additional deficit reduction could include tax increases, but only if:
  • 7 of 12 Members of a new Joint Committee of Congress agree to raise taxes, including at least one Republican Member of the Committee;
  • and a majority of the House and Senate vote for the Committee’s recommendations;
  • and the President signs the bill into law.
  • For more details on tax increases in the Joint Committee process, please see my other two posts today.

Assuming the language has been tightly drafted enough, this process should result in $1.2 T – $1.5 T of additional deficit reduction no matter what. There are four possible outcomes from this process to produce that deficit reduction:

1. across-the-board spending cuts automatically happen in defense and non-defense discretionary spending (deeper in defense), Medicare, farm and housing subsidies and a few smaller entitlements; or
2. a bill becomes law that cuts spending only, with the makeup of the spending cuts determined entirely by the new Joint Committee (and including any spending the Committee wants); or
3. a bill that cuts spending and raises taxes comes out of the Joint Committee and becomes law; or
4. some combination of (1) with (2) or (3).

As stated above, the President gets $900 B of debt limit increase effectively immediately.  The amount of the President’s last “leg” of debt limit increase depends on what happens with this Joint Committee and a Balanced Budget Amendment:

• If the Joint Committee process implodes or produces less than $1.2 T of deficit reduction, then the President can get a final debt limit increase of $1.2 T;
• If the Joint Committee process results in a law that reduces the deficit between $1.2 T and $1.5 T, then the President can get a debt limit increase of the same amount;
• If the Joint Committee process results in a law that reduces the deficit by more than $1.5 T (don’t hold your breath) or if a Balanced Budget Amendment passes the House and Senate and is sent to the States, then the President can get a final debt limit increase of $1.5 T.

Balanced Budget Amendment

The House and Senate will each vote on a Balanced Budget Amendment between October 1 and December 31 of this year. If the House passes a version of the BBA, the Senate must “consider” that version.

Senate budget resolution deemed

The Senate, which has not passed a budget resolution in two years, will be “deemed” to have passed a budget resolution for this year and next year. In other words, for the purpose of budget points of order on the Senate floor, it will be as if the Senate had done a budget resolution. This will apply to both FY12 (this year) and FY13 (next year), meaning there will be no pressure for the Senate to consider a budget resolution on the floor before 2013.

Senate Budget Committee Chairman Conrad will reportedly commit to at least a committee markup of next year’s budget resolution.

That’s your quick summary of this bill.  If you’d like to learn more, I have two additional posts:

1. Understanding the Budget Control Act of 2011. (This is an advanced topics post, not for the faint of heart.)
2. Strategic analysis of the Budget Control Act of 2011.