Frankly, I was unhappy that President Obama appeared to be reneging on his promise not to put entitlements on the Fiscal Cliff table. He seemed to have walked back from his promise not to compromise to seduce the Speaker of the House, John Boehner, into agreeing to extend the Bush tax cuts for 98 percent of taxpayers. The top two percent would see their marginal tax rates rise from 35 percent to about 39.6 percent. Boehner's Plan B fell through--he could not garner enough votes from his caucus to pass it. This caused a reset to Obama's initial demand that income earners above $250,000 a year pay their fair share toward bringing the deficit down. The deficit fix should not be on the backs of the middle class and the poor. In fact, it can be shown that higher tax rates on the order of 70 to 90 percent, rather than anti-growth, before the 1980s explain a great deal of investments in the U.S. One reason for this was that people had to make logical pragmatic choices like giving 70 percent of their next dollar to Uncle Sam or spending (investing) it on expanding their businesses. Guess what they did. You're right, they plowed it back into their businesses.
But another source of revenues and an alternative way to deal with the deficit could come from the now inexistent sales tax on trade in financial assets. Dean Baker et. al. addressed this issue in December 2009 in a paper titled The Potential Revenue from Financial Transactions Taxes, FTT. The authors projected a potential increase in revenues from United States financial transactions taxes of between $178.9 to $353.8 billion, portions of which could have been used to reduce the deficit. These taxes would apply to stock and equities, bonds, options premiums, foreign exchange spot transactions, futures, and swaps. When we impose a cost on people, they change behavior. A higher price on gasoline causes people to reduce their gasoline consumption over time. So a financial transaction tax might change behavior or not. Dean Baker et. al., therefore, calculated three possible effects of the FTT on sales: 0 percent, 25 percent, and 50 percent reduction in trading volume. The expected revenues from FTT in billions of dollars: $353.8, $265.3, and $178.9, respectively.
However, there is no apetite for taxing the rich or taxing financial transactions. Republicans prefer not to raise taxes on the rich. They say spending needs to be addressed even when that means cutting back on entitlements: Medicare, Social Security and Medicaid. They ask the middle class and the poor to take the hit for fixing the deficit but give the rich a pass.
On the question of the Fiscal Deficit, President Obama appeared to have been willing, in the name of compromise, to reduce future benefits to Social Security beneficiaries or perhaps reduce the rate of increase in benefits. This might have to be carried out with some stealth by changing the formula for calculating increases in Social Security due to inflation. To understand this better consider again how price acts on behavior--it tends to modify it by changing real income and relative prices. Economists like to say that when price changes the quantity of goods consumers buy change as well. But the change is in the opposite direction. If the price rises on a consumer good--cars, coffee, gasoline, plane tickets, education, etc.--people buy less of it. Why? The intuitive answer is higher prices reduce real income; that is, what dollars can really buy. So not only your overall consumption declines, but consumers also try to find a cheaper substitute product to consume. For instance, if the price of Coke rises I might buy Pepsi instead.
People on Social Security get a cost-of-living adjustment, COLA, which is tied to inflation. One way of calculating inflation takes base-year (say, 2011) quantities purchased and current (say, 2012) and base-year prices into account. In particular, the standard consumer-price index (CPI) computation ignores changes in consumption behavior due to prices changes. In the standard CPI the top half of the formula (the numerator) is like the bottom half (the denominator), except for the prices. So changes in prices in the current period will cause the inflation index to change. When the price of a good changes, it is unrealistic to assume that the quantity bought by the consumer does not also change. Price changes can be due to changes in quality of products (like computers, calculators, cell phones, etc.) with embedded new technology.
Now, to get the chained CPI all we need to change is the quantity in the numerator so that the top half of the formula alluded to in the preceding paragraph looks different from the bottom half. What this does is account for changes in quantity consumed due to changes in prices--a more realistic expectation of human behavior. However, for purposes of Social Security recipients, the chained CPI is likely to report a lower inflation rate, and thus reduce the increase in the Social Security COLA than that associated with the standard CPI calculation.
Simple numerical example:
In 2011 you purchased a pair of slacks for $50 and three shirts at $45 each. Then in 2012 you bought two shirts at $40 each and 1 pair of slacks for $55. We want to see the effect of buying two shirts. First we calculate the standard CPI for the data for the two years; then the chained weighted CPI for the same period.
Standard CPI = [(1X40) + (3x55)]/[(1X50) + (3X45)] = 1.11
Now the chained CPI can be calculated changing both prices and quantities in the next period. Thus,
Chain CPI = [(2X40) + (1x55)]/[(1X50) + (3X45)] = 0.73
In the first instance, with the standard CPI prices rose 11 percent over a year ago; while in the chained CPI example prices fell 27 percent. The government pays out less (nothing perhaps) and thus saves money. This manipulation of the COLA might save money going forward by reducing the deficit from presumably excessive government spending. But Social Security is not the source of the deficit--the program is solvent. And its solvency can be sustained indefinitely through revisions of the payroll tax. One way to do this is by removing the $110,100 limit for Social Security contributions.
Social Security is supported through payroll taxes on both employees and their employers up to a legal limit. Similarly, Medicare is paid for by workers, but there is no limit on taxable earnings for Medicare's Hospital Insurance taxes. So when these workers retire they are entitled to the benefits they receive. This does not make them lazy moochers. A breakdown of workers' contribution to Social Security and Medicare is shown below from a Social Security Administration publication.
"For 2012, the maximum taxable earnings amount for Social Security (OASDI) taxes is $110,100. There is no limitation on taxable earnings for Medicare's Hospital Insurance (HI) taxes.
1. The Social Security tax rate for employees is 4.2 percent through the end of the year.