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Pozen warns that inaction on fiscal cliff is likely

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Congress will likely go over the fiscal cliff come March 1 without taking action to avoid $1.2 trillion in automatic spending cuts, according to an Ivy League professor speaking at an investment conference that concluded on Tuesday.

Presenting at the Investment Management Consultants Association’s 2013 annual meeting in New York City, Harvard Business School Professor Robert Pozen told the assembled IMCA members that Congress will permit $1.2 trillion in sequestration cuts. To be evenly divided between domestic and Department of Defense appropriations, the sequestration cuts are probable because of the lack of political will to reform entitlement programs and slash the DOD budget.

“That Congress will do nothing is a sure bet,” said Pozen. “Republicans and Democrats simply won’t agree on anything.

“Republicans were once appalled by the sequester because of the huge defense cuts it entailed,” he added. “But given the current deadlock, they now realize the only serious chance they have to get substantial cuts to the budget is by doing nothing.”

Pozen said that sequestration may prove to be not as bad as critics warn, but insisted Washington would be wise to consider a more progressive approach to the federal budget deficit and national debt.

Currently at 70 percent, the ratio of the national debt to gross domestic product is projected to grow to 90 percent if current federal spending and revenue continue on their current path. To maintain the current debt to GDP ratio, Pozen said, Congress and the president will need to achieve $3 trillion in cuts over the next 10 years.

The federal tax code, revised on January 1 by enactment of the American Taxpayers Relief Act, will close the budget deficit by about $550 billion. Given $420 billion in defense cuts made in 2011, Pozen estimated that Congress would agree to no more than an additional $300 billion in cuts from the defense budget, or half of the amount called for under sequestration. Greater cuts, he said, would meet with insurmountable opposition on both sides of the aisle, in part because of concerns the nation might otherwise be unprepared for an international crisis; and because such cuts would be politically unpalatable in Congressional districts that benefit from military spending.

Turning to health care, Pozen said the Patient Protection and Affordable Care Act (PPACA) is not, as first touted, revenue-neutral: Increased spending provided by the new health care law will more than offset anticipated health care spending cuts.

PPACA, Pozen said, calls for the states to raise the maximum household income (for a family of four) that would qualify for Medicaid eligibility to $29,000, or 133 percent of the current poverty level of $22,000. Since the U.S. Supreme Court nullified this requirement when it reviewed the legislation, the increase is now optional.

“I predict the only the states that will not agree to raising the Medicaid percentage to 133 percent are those states whose governors will be competing for the GOP nomination in 2016,” Pozen said. “Most states that work through the budget numbers will agree to the revision. Nonetheless, states that are already struggling financially will be struggling even more once the health care law is fully in effect.”

For PPACA to be revenue-neutral, he added, the Congressional Budget Office estimated the administration would need to secure $716 billion in Medicare spending cuts over 10 years.

Cutting doctors’ reimbursement rates, a proposal repeatedly rejected by Congress in recent years, isn’t a viable option because then more doctors would opt out of the system. Increasing the Medicare eligibility age to 67 from 65 would also not yield significant savings, Pozen said, because individuals aged 65-67 who don’t yet qualify for Medicare would qualify for health premium subsidies under PPACA.

“I used to think that extracting significant savings from the Medicare and Medicaid programs was possible, but I no longer believe so,” Pozen said. Because of the interaction between Medicaid and Obamcare and between Medicare and Obamacare, any savings you achieve under one program or the other, you then lose under Obamcare.

“But we’ve come to a point we can’t keep shifting from one pocket to another pocket,” he added. “We have to actually reduce overall healthcare spending.”

One PPACA proposal, since rejected, that would have yielded real cuts is the elimination of tax deductions and exclusions under a “Cadillac tax” for families paying annual healthcare premiums greater than $15,000 annually. Under the final healthcare bill, this threshold was pushed to $27,500, well above the level that most families pay on the healthcare premiums, Pozen said.

Turning to Social Security, which is projected to become insolvent in 2033, Pozen said the program could be put on a financially sound footing by shifting the method by which payments to Social Security recipients are determined from the Consumer Price Index to “Chain CPI.” The latter, Pozen said, is a superior method for calculating the costs of goods and services because it factors in substitutions that people make as prices rise.

A second option – switching the formula for calculating an individual’s initial Social Security benefits from wage-indexing to price-indexing – would “wipe out” 100 percent of the $8.6 trillion Social Security trust fund deficit. That’s because, over long periods, wages grow about 1 percent faster than prices when factoring in both household consumption and savings.

Because such a switch would prove painful to low households (those earning below $25,000), Pozen suggested adopting a hybrid model.

This would entail maintaining wage-indexing for one-third of households in the bottom tier. The top one-third of households by income would shift to price indexing. And those occupying the middle income tier would be subject to a mix of both wage- and price-indexing.

“My progressive indexing proposal, which the editorial boards of both the Wall Street Journal and The Washington Post support, would cut the long-term Social Security trust fund deficit by $8.6 trillion to about $4 trillion or $4.5 trillion,” Pozen said. “This doesn’t solve the whole problem, but it’s serious money. And it’s what the markets are looking for: long-term spending reductions that show that Congress is committed to financial discipline.”

But Pozen warned that Congress is unlikely to heed this or other budget proposals because of the current political gridlock. Hence, the path of least resistance: doing nothing and the resulting $1.2 trillion in automatic spending cuts.

“If Congress can’t agree on reasonable spending cuts and revenue increases, then the sequestration may not be so bad,” he said. “Yes, we’d like to have approach the federal budget with a finer scalpel. But we shouldn’t let the best outcome be the enemy of the good. And sequestration is probably as good as we’re going to get.”