Former Obama budget chief Peter Orszag has made a startling warning: A middle-class tax increase is unavoidable, but it will probably take a bond crisis to push politicians to act.
“International investors would be wise to pay close attention to fiscal trends within the U.S.,” Orszag writes in the Financial Times opinion section. The former director of the Office of Management and Budget is now a vice chairman of global banking at Citigroup.
Obama fought hard to stave off a middle-class tax increase, bowing to pressure to delay tax increases on wealthy Americans in a two-year deal with Republicans that also kept down taxes on those earning under $250,000.
Meanwhile, the U.S. debt has hit $14 trillion and foreign holders of U.S. bonds are rightly nervous about the potential for a federal default.
Orszag says that the correct path forward is increased stimulus and then major deficit reduction to take place in two to three years.
The payroll tax holiday in the Obama tax bargain has taken care of the stimulus but nothing has been done about the deficit, he writes.
“Most fundamentally, it is difficult to see how the medium-term federal deficit can be reduced to sustainable levels without additional tax revenues from those earning less than $250,000 a year. And yet it is equally difficult to see the political system embracing that reality without being forced to do so by the bond market,” Orszag writes.
He goes on to predict a fiscal crisis unless policy makers move on the deficit.
At the state level, he predicts not bankruptcy but a general stoppage in state government, since bondholders are “privileged creditors” in most states. At the city level, Orszag predicts, we could see bankruptcies, but some will fall back on states for bailouts.
“Even if the relevant state government decides not to step in, and a city is forced to default, the direct macroeconomic consequences are unlikely to be substantial—unless that default triggers others to follow,” Orszag writes. “In this scenario the possible contagion effect among investors in the debts of different cities is a crucial consideration.”
Republicans have raised the stakes on the state bankruptcy idea, floating a plan to let states go “out of business” and thus renegotiate labor contracts and pensions strangling state budgets in the recession.
“We’re going to look at state and municipal budget issues, their unfunded and underfunded pension liabilities as well as the impact defaults and bankruptcies of municipalities would have on the bond market,” Rep. Patrick McHenry (R-NC) told Bloomberg News.
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