University of Southern California

Taking a Long-range View of the Fiscal Cliff
Marshall Professors Offer Pragmatic Solutions to the Slowing U.S. Economy in New Book
September 28, 2012 • by News at Marshall

During this election year, there has been much talk about the precarious “fiscal cliff” the American economy faces. Part of the problem, according to Selahattin (Selo) Imrohoroglu, academic director and assistant dean of IBEAR and professor of finance and business economics at USC’s Marshall School of Business, is the short-range nature of previous policy measures and the current focus on what is projected to happen in the next few years. Imrohoroglu and his wife Ayse Imrohoroglu, professor of finance and business economics at Marshall, take a long-range view of both the issues impacting the American economy and the solutions needed to redress the current malaise and potential recurrence of recession in their new book The Fiscal Cliff. Selahattin Imrohoroglu shared some of the book’s insights in the following Q & A:

How would you define the fiscal cliff?

In our book we define the “fiscal cliff” as the tremendous increase in federal government debt, relative to national income, projected over the next two decades, unless corrective action is taken right now. Note that we are not talking about the fiscal issue we are facing next year. Rather, we are taking a longer term view of the U.S. economy and alerting the reader to negative effects on the economy unless two measures are taken: 1) broaden the tax base without raising tax rates (by eliminating tax expenditures such as the deductibility of home mortgage interest payments and the premia of employer sponsored health insurance), and, 2) lower projected government spending, especially health expenditures.

The government can raise taxes in two ways: make more income taxable (eliminate deductions and exemptions) or raise marginal income tax rates. Economists agree that raising marginal income tax rates are bad for the economy. Therefore, policy makers ought to raise the tax base instead. They may even be able to offer reductions in marginal income tax rates (and provide an incentive to increase economic activity) if they raise sufficient revenue this way.

There is no way we can solve our fiscal imbalance with one instrument. Raising tax revenue through less tax spending gets us part of way to where we want to be. The other part is to reduce the projected federal spending on health expenditures. Extending the retirement age from 67 to 68 would also help restore fiscal balance.

What is the state of the U.S. economy today? And what measures, policies or beliefs brought us here?

The U.S. economy is growing very slowly, with a slow growth in job creation also. How did we get here? In short, by kicking the can down the road by not tackling our fiscal problems early on. Successive administrations catered to various special interests and allowed significant income items to be “tax-free,” thereby shrinking the tax base by about $1 trillion per year. To make up the lost dollars, the government relied on high marginal tax rates that discourage job creation and growth. In addition, strong lobbying by other/similar groups added a large burden on future generations by increasing the generosity of social insurance programs, especially on health expenditures. The end result is huge uncertainty about the future state of the economy with lower than historical tax revenues and very high projected government expenditures.

If I’m a business person, if I am a corporate CEO, I’m not going to decide a huge investment project and spend hundreds of millions of dollars because I have no idea what the future tax rates will be, both from a corporate income side and also from the personal income side. I just don’t know if there will be such an increase in U.S. government debt that will raise interest rates. Therefore, I won’t be able to pay my own debt back to the banks so there is a tremendous amount of uncertainty faced not only by the corporations but also by households. So that’s why you see an increase in savings, both by the corporations and by households these days. People are just unsure about how the next five years, 10 years will look like and that’s really not good for job growth, job creation and economic growth.

What is needed to avert another widespread U.S. recession, aka falling off the fiscal cliff?

The focus on the short run is the big problem. This is how we got here. Instead, there has to be a longer term fiscal policy that is bipartisan and that addresses the main issues we raised above. The fiscal imbalance is what we have to focus on.

Our book is intended as a nontechnical introduction to the role of the government in the economy with a particular focus on how we can restore fiscal balance in United States between now and 2035.

About the USC Marshall School of Business
Consistently ranked among the nation's premier schools, USC Marshall is internationally recognized for its emphasis on entrepreneurship and innovation, social responsibility and path-breaking research. Located in the heart of Los Angeles, one of the world's leading business centers and the U.S. gateway to the Pacific Rim, Marshall offers its 5,700-plus undergraduate and graduate students a unique world view and impressive global experiential opportunities. With an alumni community spanning 123 countries, USC Marshall students join a worldwide community of thought leaders who are redefining the way business works.