Fiscal Cliffs and Credible Commitments

While foreign and domestic policy are very different, I believe that the rationalist approach to international bargaining sheds some light on some of the issue surrounding the “fiscal cliff”.  The fiscal cliff is itself an interesting example of one of Thomas Schelling’s concepts, “precommitment”, which got me thinking about it.  Let me start with the real point: if we assume that deficit reduction is the goal of these negotiations*, Democrats are making a huge mistake by putting tax increases for the rich at the top of their agenda.  Why? Tax increases have a very low expected value of deficit reduction.

The fundamental issue here is that Republicans run on tax cuts basically every election.  If a Republican wins in 2016, he will be expected to roll back the Obama Tax Hikes (39% marginal tax rate on income over $250K).  The Obama Tax Hike has a value of $80B in revenue per year – using the conventional 10-year budget scoring window, their nominal value is $800B.  However, I would peg their expected value at around half of that – 100% of their nominal value for 2013-2016, and then close to zero beyond 2016.  At this point, it’s impossible to judge the result of the 2016 election but the baseline expectation should be for Republicans to win, since threepeats are quite rare.

There is no way for Congress to credibly commit future Congresses to anything.  This is the problem with deficit “grand bargains” in general, but particularly with taxes.  If taxes do go up in this deal, it is virtually certain that Republicans will campaign in 2014 and 2016 on big deficit-busting tax cuts.  Given the way that they have reacted to the Medicare cuts in Obamacare, it is quite likely they will also campaign against any cuts made in entitlement programs.  In short, the expected value of deficit reduction stemming from any deficit reduction deal is considerably below the face value, with revenue increases at a much steeper discount than spending cuts.

Republicans face a similar problem with Democrats, by the way.  It’s certainly plausible that a Democratic President in 2016 will be expanding food stamp spending and burning money on an expensive new war.  I think the worry is asymmetric, however – note how PAYGO is only applied during Democratic congresses.

In short, game theory sez: Republicans cannot credibly commit to holding their side of a “grand bargain”.  It would be frankly stupid for Democrats to implement bad policy in order to secure deficit reduction, especially if it comes in the form of new revenues that have a very high discount relative to nominal value.

*: This is debatable, but assumed for the purpose of argument.

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