Grading the Deficit Commission: Although New Proposal Cuts Billions in Federal Spending, The Shortfall Remains

The two leaders of U.S. President Barack Obama's Deficit Commission Wednesday produced a proposal for deficit cuts that slaughtered a lot of budgetary "sacred cows" and cut $3.8 trillion off the deficit over the next 10 years.

And the cuts were even made in just the right ratio – with $3 of spending cuts for every $1 of tax increases.

But if there was ever a proposal that exemplified that saying "the devil is in the details," this surely is it – for everyone will find something in here that they hate.

Let's take a look at the bits that I hate – after which I'll point out the proposal's strong points, before giving the commission leaders my final grade for their work.

The Good, the Bad and the Ugly

Known officially as the National Commission on Fiscal Responsibility and Reform, the Deficit Commission was formed by President Obama early this year to identify "policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run." It first met in late April.

The proposal released Wednesday was crafted by the commission's two co-chairmen, and is now slated for review by the rest of the members of the panel.

They've been given a daunting assignment. In the wake of the biggest financial crisis since the Great Depression, the U.S. federal government is looking at running $8 trillion in deficits over the next 10 years. If that forecast becomes a reality, the already-onerous national debt would soar to more than $20 trillion. And even if the panel's proposals were adopted without change, the United States would still be looking at deficits of $350 billion a year.

The $3.8 trillion deficit-cutting plan the commission unveiled this week would pare Social Security and Medicare, would eliminate tax breaks (including the popular mortgage-interest deduction), and would cut income-tax rates.

As proposed, the Deficit Commission proposal would slash the annual U.S. budget deficit from $1.3 trillion this year to roughly $400 billion by 2015 and would start reducing the $13.7 trillion national debt, according to a Bloomberg News report.

The plan only reduces spending to 22% of gross domestic product (GDP), which means that federal outlays will remain substantially higher than the historical norm of 20%. At the same time, the plan calls for taxes to increase to 21% of GDP, significantly higher than their historical level of around 18%.

Thus, the bad behavior that's been a hallmark of the White House and Congress of the last decade is to some extent set in stone, even if some of the excesses of the last couple of years are removed. That's partly because the proposal does nothing about the "Obamacare" healthcare legislation, which very clearly will add an amount equal to at least 1%-2% of GDP to federal spending by 2020.

I can understand why the panel didn't touch Obamacare: It's too much of a political hot potato, and Obamacare does provide some clear benefits in terms of increased coverage. However, there's no question that big savings could be achieved by bringing the free market more fully into healthcare, and that hasn't been done. 

Conversely, the Deficit Commission's work on taxes is almost wholly admirable. It gives three options, each of which has the effect of reducing both tax rates and deductions. That would push the current U.S. tax system back towards what we had immediately after the sweeping Tax Reform Act of 1986 – which I still believe was the single-best piece of tax legislation that I've seen in my lifetime.

The home-mortgage-interest deduction is economically very damaging – as we more or less proved in 2002-06 – since it diverts capital artificially away from productive enterprise and into unproductive housing.

The employer deduction for health insurance premiums is also damaging from an economic standpoint. But if you're going to abolish it, which increases costs, you need to make major changes in the healthcare system to remove the cross-subsidization, restrictive practices and legal leeching that makes this country's healthcare the most expensive in the world.

The Deficit Commission's proposals on the capital-gains tax and the dividend tax are just plain wrong.

The proposal calls for the capital-gains levy to be increased to 28% and dividends to be taxed as ordinary income. Since dividends are paid out of income that has already been taxed at the corporate level, their tax should be reduced to zero – or, better, dividends should be made tax-deductible from corporate income. As for the capital-gains tax, 40 years of experience has demonstrated conclusively that the revenue-maximizing level for this is 20% – and no higher.

The commission makes proposals that would cut spending by $200 billion by 2015. Cuts to achieve this would include a 10% cut in the federal work force and a $3 billion cut in farm subsidies.

That's fine, but it's only a down payment on what's really needed.

The Road We Need to Travel

There is no earthly reason why the federal government should not be expected to live on the 18.2% of GDP that it absorbed in 2000, at the end of a two-term Democrat presidency. Therefore, getting the federal expenditure down to 22% of GDP – as the Deficit Commission proposes – is a hopelessly un-ambitious target.

To get that additional, needed 3.8% of GDP – we're talking about roughly $550 billion annually – all we should have to do is apply good management and be willing to excise some of the foolish excesses of the past decade.

With Social Security, the commission proposes two changes:

• To increase the retirement age to 68 in 2050 and 69 in 2075.
• And to fiddle – yet again – with the consumer price index (CPI), using a "chained" index to adjust Social Security payments.

That last gimmick is just that – and it's flat out just a plain rip-off that, far from overstating inflation, actually understates it.

Since 1980, the CPI has not accounted properly for housing costs. Since 1996, it has included a "hedonic" adjustment that accounts for the (overstated) consumer benefits from increases in computer processing power, but not for the consumer costs of automated-telephone-answering systems, misguided computerized billing processes and similar price offsets.

Using a chained index for Social Security adjustments consistently underestimates the impact of inflation – which over time will put the country's senior citizens in a financial squeeze.

At the same time, however, since we are raising the retirement age by a month a year currently, getting to 67 by 2026, why not continue doing so, making the retirement age 68 in 2038, 69 in 2050 and 70 in 2062? Doing this would solve Social Security's funding crisis in perpetuity, rather than just over the artificial 75-year accounting period used by the government actuaries.

If we grade the area of Medicare/Medicaid, the Deficit Commission clearly and completely flunks. It proposes setting cost goals for those programs to kick in after 2020, and then sets price goals to meet those cost goals. That won't work, because it will move the medical system further towards government micromanagement and further from the market.

A complete review and retooling is needed on the U.S. healthcare system, but that's very unlikely to occur under the present political configuration.

So where does that leave us?

The Deficit Commission's proposals don't solve the U.S. budget problem entirely, but they do make considerable progress towards solving it. The concern here is that Congress – in its usual fashion – will take only the commission's bad ideas and neglect the good ones.

For example, I'd be willing to wager that we don't get lower marginal tax rates out of all this.

But overall it is a start.

So let's give it our final grade – a solid "B-minus."

[Editor's Note: If you have any doubts at all about Martin Hutchinson's market calls, take a moment to consider this story.

Three years ago – late October 2007, to be exact – Hutchinson told Money Morning readers to buy gold. At the time, it was trading at less than $770 an ounce. Gold zoomed up to $1,000 an ounce – creating a nice little profit for readers who heeded the columnist's advice.

But Hutchinson wasn't done.

Just a few months later – we're now talking about April 2008 – with gold having dropped back to the $900 level, he reiterated his call. Those who already owned gold should hold on, or buy more, he said. And those who failed to listen to him the first time around should take this opportunity to remedy their oversight, he urged.

Well, we all know where gold is trading at today – at about $1,410 an ounce.

For investors who heeded Hutchinson's advice, that's a pretty nice neighborhood.

Investors who bought in after his first market call are sitting on a profit of as much as 83%. Even those who waited, and bought in at the $900 level, have a gain of about 60%.

But perhaps you don't want just "one" recommendation. Indeed, smart investors will want an ongoing access to Hutchinson's expertise. If that's the case, then The Merchant Banker Alert, Hutchinson's private advisory service, is worth your consideration.

For more information on The Merchant Banker Alert, please click here. For information about Hutchinson's new book, "Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System," including how to purchase the book at a 34% discount, please click here.]

News and Related Story Links:

• Merchant Banker Alert:
  Official Website.
• Bloomberg News:
  Deficit Plan Matches $3.8 Trillion Math With Tough Politics.
• Money Morning News Archives:
  Obamacare News Stories.
• FiscalCommission.gov:
  Official Website of the National Commission on Fiscal Responsibility and Reform.
• Wikipedia:
  Perceived Underestimates of Inflation.
• Money Morning Investment Research:
  When Investing in Latin America, Politics Point the Way to Profits.
• Wikipedia:
  National Commission on Fiscal Responsibility and Reform.
• Wikipedia:
  Tax Reform Act of 1986.
• Money Morning:
  Author Chat: Money Morning's Martin Hutchinson Talks About "Alchemists of Loss"