There are contradictions between deficit reduction and recession avoidance. There is a way to thread the needle, but it is not without risk.
- Let the sequester go through. It cuts spending by $110 billion a year ($1.1 trillion over 10 years) and, along with tax increases enacted by the last Congress on January 2 of this year, puts fiscal policy on a sustainable path – one that stabilizes and then reduces the debt-to-GDP ratio over the coming decade.
- Focus on enacting revenue-neutral tax reform and entitlement reform this year. Reduce marginal tax rates and close loopholes. Enact legislation that rationalizes Social Security, Medicare, and Medicaid programs with phased in changes, including gradual increases in eligibility age and means-testing. These measures will reduce uncertainty and improve resource allocation, thereby boosting growth.
- Hold fast to these measures in the face of heavy criticism. Growth will slow this year but rise thereafter given clarity on a sustainable path for fiscal policy and better resource allocation.
Change creates winner and losers, but these measures will make the overall pie larger.