Budget Solution: Squeeze the Middle

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The Wall Street Journal
By: Sara Murray
July 13, 2011

GLOUCESTER COUNTY, N.J.--Like many in this middle-class suburb, Chad Flexon sees the efforts of Washington politicians to cut the budget deficit as far removed from his life.

"I can't see myself, being where I am, being that greatly affected by anything that gets passed," says Mr. Flexon, a 26-year-old teacher who, with his wife, a store merchandise coordinator, earned well under $100,000 last year.

Yet the Flexons, like most middle-class Americans, benefit from the kinds of federal tax and spending programs now under scrutiny. A home-buyer tax credit helped them buy a townhouse in 2009, with its down payment held low by a federal mortgage-insurance program. Their federal income-tax tab last year was reduced through $12,800 in deductions for student-loan interest, medical expenses and mortgage interest.

Neither President Barack Obama nor Republicans say they want to target the middle class. But budget gaps projected for the next decade are so large they can't be reined in without hitting those in the middle. There simply isn't enough income at the top to tax, nor enough spending on people at the bottom to cut.

The debt-ceiling talks at the White House to reduce the deficit no longer seek a broad bargain that would embrace a wide variety of changes to both spending and taxation. But even if the plan that emerges shields the middle class--one rough definition of which is households between the lowest 40% and top 10% in income, or $33,500 to $163,200--they will surely be affected by spending or tax changes in some future round of deficit-cutting, budget analysts and economists agree.

"You can't address our fiscal situation without asking the vast bulk of the middle class to make a contribution," says Robert Reischauer, a Democrat and former Congressional Budget Office director.

"It's pretty clear that there isn't enough money to just tax the rich," says Douglas Holtz-Eakin, a Republican and also a former CBO director. "I don't think the strategy will be let's hammer the poor. By process of elimination, you end up touching many more Americans."

Mr. Flexon in Gloucester County, a fast-growing suburb of Philadelphia, doesn't see why, if Washington needs more revenue, it should come from people like him. He supplements his schoolteacher pay by working as a lacrosse coach, college-prep tutor and wedding DJ. "There's so many people at the top that make so much money, why is there an issue?" he says.

But Mr. Obama's hope to end Bush-era tax cuts just on the $250,000-a-year set, after 2012, would raise only $700 billion over a decade. Meanwhile, deficits would total a projected $10 trillion over a decade if Bush-era tax cuts stay in place for all, other tax and spending policies also remain unchanged and the economy recovers as currently predicted, according to an analysis of Congressional Budget Office data.

The deficit is now about 10% of gross domestic product. To get it to 3%, a level many economists deem sustainable, by 2015 solely by raising taxes on $250,000-plus households would require more than doubling their top tax rate to 76.8%, according to the Tax Policy Center, a nonpartisan number-crunching think tank. That is political poison, and, in the view of most economists, it would also be economically imprudent, discouraging income-earning work and encouraging tax-sheltering.

But reducing the deficit exclusively by cutting spending on the bottom isn't practical, either. If Congress had wiped out welfare cash assistance, food stamps, jobless benefits, children's health insurance, Supplemental Security Income for aged poor, housing assistance and the lion's share of training, employment and social-services programs, federal spending in fiscal 2010 would have been lower by about $489 billion, which is only about a third of that year's deficit.

What's left? A significant chunk of federal spending goes for the basics of government--often invisible or taken for granted, but in the sights of congressional spending-cutters. These are programs like defense, the Federal Bureau of Investigation, the Environmental Protection Agency and grants to cities and states that benefit, even if indirectly, people in a place like Gloucester County.

In the county, a bedroom community of 288,000 where the median family income is $69,900, the U.S. government pumped in $1.6 billion in retirement and disability benefits, grants, procurement contracts and wages for federal employees living here in fiscal 2009, the Census Bureau estimates. That's $16,000 per household.

Social Security and Medicare, which account for a third of federal spending, apply to everyone regardless of income. A quarter of families in Gloucester County get Social Security, the Census estimates. Nationally, 15% of Americans are on Medicare. Medicaid is for the poor, but it has become the insurance of last resort for elderly who were once in the middle class but ran out of money for nursing-home bills.

Growth in the benefit programs, if they are left unchanged amid Baby Boom retirements and slowly lengthening life spans, eventually would force higher taxes or deep spending cuts elsewhere in the budget. Even modest-sounding tweaks would be felt by the middle class.

One idea under discussion in the current talks to cut the deficit enough to pass a debt-ceiling increase is to use a different version of the consumer price index to adjust tax brackets and Social Security benefits for inflation. It would be an index that rises more slowly.

The Congressional Budget Office says this would reduce projected deficits by $90 billion over 10 years through increased tax revenue, and 31% of that would come from taxpayers earning $50,000 to $100,000. The change would cut spending by $131 billion through smaller cost-of-living adjustments to Social Security and federal-employee pensions.

On Medicare, the perennial Washington move is to squeeze health-care providers and assert that beneficiaries aren't affected. That approach may no longer suffice. Several deficit-cut proposals would make beneficiaries shoulder future Medicare cost increases above certain targets.

Some members of both parties propose raising the eligibility age for Medicare to 67 from 65, an idea Mr. Obama floated recently. That would save $125 billion over a decade, leaving much of the cost to be borne by the middle class and its employers.

Julia Pisacreta is one Gloucester County resident who has little doubt Washington's deficit-cutting will touch her. Ms. Pisacreta, a 36-year-old drug-company representative who with her husband earns about $200,000 a year, isn't banking on Social Security and Medicare. "I just assume things will be taken away and I just assume I'll be paying more," she says.

The more deeply federal spending is cut, the more likely the middle class is to be affected. But looking to higher tax revenue as a solution also could ding the middle class.

Middle-class taxpayers would pay more federal taxes if not for a host of income-tax deductions, exclusions and credits that are under scrutiny in Washington's quest to raise revenue without changing tax rates.

Take mortgage interest. By letting Americans subtract this from their incomes, the government gave up nearly $79.2 billion in tax revenue last year. The middle class gets over half of the benefit of this deduction. In Gloucester County, 80% of families are homeowners. Nationwide, it is 67%.

Chris Bjanes, 38, and her husband built a four-bedroom arts-and-crafts-style home here in 2001. Rising property taxes help fund the school system, where she works as an art teacher. She and her husband are able to deduct these property taxes on their federal income-tax return, a provision that reduced federal revenue by $15.1 billion last year.

Ms. Bjanes and her husband, a graphic designer, earned $127,000 last year and paid about 12.6% of it, or $16,000, in federal taxes. They reduced their tax tab by deducting $6,000 in mortgage interest and nearly $11,000 in property taxes. They took advantage of other tax preferences to set aside money for their daughter Charlize's college education and their retirement, in Roth IRAs.

In prior years they received the federal Child Tax Credit, and when Charlize was in child care, an additional credit for that. Those child credits reduced tax revenue to the U.S. government by $26.5 billion last year.

Until last year, Ms. Bjanes's employer paid the whole cost of her health care, a benefit on which she didn't owe any tax. Excluding employer-provided health insurance from workers' incomes is the single biggest benefit in the tax code, one that reduced federal revenue by $160 billion last year. The middle class is the biggest beneficiary.

The government already has targeted that provision. The Obama health-care law levies a 40% tax on so-called Cadillac health plans, those few that cost more than $27,500 for a family in 2018. Over time, the tax is intended to hit more workers, giving them and their employers incentives to spend less on health care.

Ms. Bjanes estimates that health insurance for her family of three is worth $20,000 annually, and it never occurred to her that Congress might consider that taxable income. "That would be a big impact," she says, "That would probably cut into our freedom of spending."

Ms. Bjanes, a registered Democrat, isn't sure how deficit reduction will affect her, if it at all.

Two congressmen who split Gloucester County aren't preparing their constituents for belt-tightening.

Rep. Robert Andrews, a Democrat, says Congress can and should slash the deficit without hitting the middle class by cutting defense spending, limiting agricultural subsidies and changing the way Medicare pays health-care providers.

He does, however, support raising the Social Security retirement age (currently rising slowly to age 67) for those now 40 or younger.

"That certainly would affect middle-class people. They wouldn't love it," Mr. Andrews says. He is quick to add that isn't on the table in the current deficit talks.

Rep. Frank LoBiondo, a Republican, says the middle class has been pummeled by the recession and will suffer more if the nation keeps borrowing. "They know that they can't do that in their own households," he says. "You can't just borrow and spend without a consequence."

Mr. LoBiondo says spending cuts should target overlapping government programs and certain industry-specific subsidies. Tax increases are a nonstarter to him, as are changes to Social Security unless there's a broad consensus to touch it.

"Is that going to be enough? I'm not sure," he says.

Write to Sara Murray at sara.murray@wsj.com

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