The Obama administration proposed a year-long reduction in payroll taxes of 2 percentage points as part of a broader compromise to extend Bush-era tax cuts temporarily, a congressional aide said.

The proposed reduction was offered as an alternative to renewing the “Making Work Pay” tax credit, a creation of President Barack Obama that expires Dec. 31 along with lower income-tax rates enacted in 2001 and 2003, the aide said, speaking on condition of anonymity. Some Senate Republicans oppose the credit.

Negotiators also are discussing including Obama’s proposal to allow a full deduction for equipment purchases that currently must be deducted over time, an administration official said. The proposal would accelerate $200 billion in tax savings for companies in the first year and benefit 1.5 million companies and several million individuals who run businesses, according to White House estimates.

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The U.S. Senate on Saturday defeated two attempts by Democrats to extend the Bush-era tax cuts for the middle classes permanently, in rare weekend votes that likely had little effect on wider negotiations to reach a compromise about extending the tax cuts.

The Senate voted 53-36 to reject an attempt to initiate debate in the chamber on a measure that would have extended lower tax rates for individuals who earn less than $200,000 and couples earning less than $250,000.

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The global prosperity of much of the 20th century would seem to belie the pessimists, but I don’t think there is much doubt the moral authority of the West has dramatically declined in the face of the financial crisis. It has revealed deep fault lines within Western economies that have spread to the global economy.

The majority of Western governments are running fiscal deficits of 10 percent or more relative to GDP, but it is increasingly clear that there will be no quick fixes, that big government and fiscal deficits will not bring us back to the status quo ante. Indeed, the tidal wave of red ink has meant that the leverage-led or debt-led growth model is dead.

Developed countries will be forced to deal with their debt on every level, from the personal to the corporate to the sovereign. Being able to borrow may have made people feel richer, but having to repay the debt is certainly making them feel poorer, particularly since the unfunded liabilities that many governments face from aging populations will have to be paid for by a shrinking band of workers.

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The chairmen of President Obama’s debt-reduction commission have been unable to win support from any of the panel’s elected officials for their proposed spending cuts and tax increases, underscoring the reluctance of both parties to risk short-term political backlash in pursuit of the nation’s long-term fiscal health.

The chairmen of the commission ”” former Senator Alan K. Simpson, a Republican, and Erskine B. Bowles, a Democrat and former chief of staff to President Bill Clinton ”” delayed for two days, until Friday, a final vote by its 18 members.

They said the delay was to provide more time to look at the final package, but it also gave them further opportunity to woo some of the 12 members of Congress on the commission, six from each party, whose support will be critical if the plan is to be taken seriously as a blueprint for eventual legislation.

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Even as work continues to repair our financial infrastructure and get the economy moving again, we need urgent action to forestall the next financial crisis. I fear that one will start in Washington. Total federal debt has doubled in the past seven years, to almost $14 trillion. That’s more than $100,000 for every American household. This explosive growth in federal borrowing is a result of not just the financial crisis but also government unwillingness over many years to make the hard choices necessary to rein in our long-term structural deficit.

Retiring baby boomers, who will live longer on average than any previous generation, will have a major impact on government spending. This year, the combined expenditures on Social Security, Medicare and Medicaid are projected to account for 45 percent of primary federal spending, up from 27 percent in 1975. The Congressional Budget Office projects that annual entitlement spending could triple in real terms by 2035, to $4.5 trillion in today’s dollars. Defense spending is similarly unsustainable, and our tax code is riddled with special-interest provisions that have little to do with our broader economic prosperity. Overly generous tax subsidies for housing and health care have contributed to rising costs and misallocation of resources.

Unless something is done, federal debt held by the public could rise from a level equal to 62 percent of gross domestic product this year to 185 percent in 2035. Eventually, this relentless federal borrowing will directly threaten our financial stability by undermining the confidence that investors have in U.S. government obligations….

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The draft recommendations of the president’s commission on deficit reduction call for closing popular tax deductions, higher gas taxes and other revenue raisers to drive tax collections up to 21% of GDP from the historical norm of about 18.5%. Another plan, proposed last week by commission member and former Congressional Budget Office director Alice Rivlin, would impose a 6.5% national sales tax on consumers.

The claim here, echoed by endless purveyors of conventional wisdom in Washington, is that these added revenues””potentially a half-trillion dollars a year””will be used to reduce the $8 trillion to $10 trillion deficits in the coming decade. If history is any guide, however, that won’t happen. Instead, Congress will simply spend the money.

In the late 1980s, one of us, Richard Vedder, and Lowell Gallaway of Ohio University co-authored a often-cited research paper for the congressional Joint Economic Committee (known as the $1.58 study) that found that every new dollar of new taxes led to more than one dollar of new spending by Congress. Subsequent revisions of the study over the next decade found similar results.

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Surprisingly, the chairmen overlooked the easiest route to reducing the deficits over the next decade: scaling back the costly budget that President Obama presented earlier this year. Much of the projected doubling of the national debt between 2010 and 2020 reflects the spending and tax proposals in that budget.

The Congressional Budget Office estimates that those proposals would, if enacted, raise the 10-year budget deficit by $3.8 trillion, even after taking into account the president’s proposed $1.3 trillion of new taxes on businesses and higher-income individuals. The $5.1 trillion gross cost of the Obama proposals reflects the cost of making the Bush tax cuts permanent for individuals with incomes below $250,000, of providing additional tax cuts for low- and moderate-income individuals, and of increasing spending on domestic programs.

As President Obama considers the bipartisan commission’s proposals and plans his next budget, he should begin by removing some of the $3.8 trillion of increased deficits that he proposed earlier this year. Financial markets and policy makers around the world want to see if the administration is as serious about deficit reduction as the American public.

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This is a good exercize.

The [Deficit Reduction] report from the chairmen lists some of the best ways to raise revenue and cut spending. But it comes with no enactment strategy. In this climate, asking politicians to end the mortgage deduction and tax employer health care plans and raise capital gains taxes and cut benefits for affluent seniors is like asking them to jump on a buzzing sack full of live grenades. They won’t do it.

So we continue on the headlong path toward a national disaster. And along the way our dysfunctional political system will leave all sorts of other problems unaddressed: immigration, energy policy and on and on.

Yet, I’m optimistic right now. I’m optimistic because while our political system is a mess, the economic and social values of the country remain sound. My optimism is also based on the conviction that serious, vibrant societies don’t sit by and do nothing as their governments drive off a cliff.

Over the past few years, we have seen millions of people mobilize ”” some behind President Obama and others around the Tea Parties. The country is restive and looking for alternatives. And before the next round of voting begins, I suspect we will see another mass movement: a movement of people who don’t feel represented by either of the partisan orthodoxies; a movement of people who want to fundamentally change the norms, institutions and rigidities that cause our gridlock and threaten our country.

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Russell Long, of the famous Louisiana political dynasty, loved to tell how his Uncle Earl, the governor, advised a city slicker politician, hit by redistricting, how to successfully court rural voters.

He should rumple up the fancy white suit, loosen the tie, toss dirt on those shiny shoes, and reach into his pocket, bring out that big wad of bills and “spread the joy.”

That is the mirror opposite of what the fiscal deficit commission, Congress and the White House should do if they want to seriously address long-term budget deficits. They have to spread the pain.

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By proposing to curtail the tax deduction for mortgage interest, the president’s deficit commission is sounding an alarm.

The home mortgage deduction is one of the most widely used and expensive tax subsidies. More than 35 million Americans claim it, and the federal government estimates it will cost the Treasury $131 billion in forgone revenue in 2012. Its size, popularity and link to the emotionally charged American notion of homeownership has made it so politically sacrosanct that there are serious doubts whether Congress will even entertain the idea.

But by raising the specter of ending one of the most cherished tax breaks, the commission is trying to jar the public into recognizing the magnitude of the nation’s budget deficit and some of the drastic steps that might be needed to close it.

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A draft proposal released Wednesday by the chairmen of President Obama’s bipartisan commission on reducing the federal debt calls for deep cuts in domestic and military spending starting in 2012, and an overhaul of the tax code to raise revenue. Those changes and others would erase nearly $4 trillion from projected deficits through 2020, the proposal says.

The plan would reduce projected Social Security benefits to most retirees in later decades ”” low-income people would get higher benefits ”” and slowly raise the retirement age for full benefits to 69 from 67, with a “hardship exemption” for people who physically cannot work past 62. And it would subject higher levels of income to payroll taxes, to ensure Social Security’s solvency for the next 75 years.

But the plan would not count any savings from Social Security toward meeting the overall deficit-reduction goal set by Mr. Obama, reflecting the chairmen’s sensitivity to liberal critics who have complained that Social Security should be fixed only for its own sake, not to balance the nation’s books.

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Anyone wondering what President Obama will face when he arrives in South Korea on Wednesday for a global financial summit meeting need look no further than an announcement by China’s leading state-endorsed rating agency, which downgraded the United States’ credit rating on Tuesday ”” and provocatively questioned American leadership of the global economy.

The agency cited the Federal Reserve’s decision to pump more money into the United States economy and warned of Washington’s “deteriorating debt repayment capability” and “the serious defects in the United States economic development and management model,” which it predicted would lead to “fundamentally lowering the national solvency.”

In the rest of the world, the United States is still the gold standard of credit risks, and the Chinese downgrade is not expected to have much real impact. But the sharply worded attack from the country that is buying billions of dollars in American debt each month was just the latest rhetorical assault on the United States, as officials from China to Germany to Brazil suggest that Washington’s addiction to debt has greatly diminished its credibility.

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China kept up a drumbeat of criticism of U.S. easy money policies on Tuesday, warning two days before a G20 world economic summit that Washington could destabilize the global economy and inflate asset bubbles.

Nearly a week after the Federal Reserve announced it was going pump as much as $600 billion into the economy, world leaders continue to bash the plan, saying it will flood global markets with cash without doing much for the U.S. recovery.

President Barack Obama acknowledged in Jakarta that the Group of 20 rich and developing nations “still have a lot of work to do” to ensure balanced global growth.

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Last week we talked about the first stage of the U.S. fiscal crisis: the slow erosion of long-term growth because of mounting government debt. This phenomenon arises from a straightforward application of conventional supply-side economics. Government borrowing absorbs private saving that would otherwise be used for capital formation. The diminished capital stock reduces productivity, growth, and competitiveness.

This week we look at stage two: a rapid economic meltdown precipitated by an untamable accumulation of government debt. Stage two is much more difficult to understand than stage one. Government debt in distress is not something that gets much attention from economists who study developed countries. It’s not something they were taught when they went to economics school. So as the possibility of a crisis has become more real, they are trying out a lot of new ideas.

One nice thing about this otherwise gloomy state of affairs is that politics has not yet infected the economics. The research that you see is not by economists who are pushing a partisan agenda, but by people who are genuinely concerned that the economy may be running itself off a cliff.

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It is undeniable that we are on the path to fiscal collapse. This decline will occur in two stages. First there is the decay as the swelling national debt wears away the economy’s foundations and commits more and more future income to foreign creditors. We are already in stage one.

In stage two a lethal combination of phenomena arises in quick succession: greater default risk, looming inflation, higher interest rates, declining growth, financial market instability, and an acceleration of government borrowing. They feed on each other. The economy heads on a downward spiral. Between stage one and stage two there is a tipping point. Experts know it will come, but nobody wants to predict when. (See below.) This article is about the slow economic decline of stage one. Next week part 2 will describe the hell of a full-blown fiscal collapse.

There is no question economics has failed us. The old paradigms have been made obsolete by the hard reality of the 2007-2009 financial crisis and soaring government debt. But some ideas can be salvaged from the wreckage.

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A grand victory for Republicans in the 2010 midterm election? Yes, of course. But also no. In all three of the most recent earthshaking midterm elections ”” 1994, 2006 and now 2010 ”” the same candidate won: divided government.

That is not a coincidence. In the last two decades, a strong and persistent pattern has emerged, one that will dominate our politics for some time to come, because it is rooted in two important political realities. First, the public strongly prefers divided government. Second, it has every reason to.

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The White House and a transformed Congress are bracing for a high-stakes battle later this month over a host of expiring tax breaks and benefits for the unemployed that will mark the first test of the new political dynamic in Washington.

If President Obama, his weakened Democratic allies and a resurgent Republican Party cannot find a way to work together, taxes will rise sharply in January for virtually every American taxpayer, and more than 3 million people will lose their unemployment checks – which together could suck more than $300 billion out of the pockets of consumers and business owners next year.

Economists across the political spectrum say such a blow would be devastating to the economy and has the potential to halt the fragile recovery in its tracks.

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France, the United Kingdom and the United States, among other countries, face a need to erase or reduce budget deficits to address a longer-term problem of growing national debt.

The economies of Portugal, Italy, Greece and Spain are an example of what can happen if countries don’t address these issues sooner rather than later.

The U.K. and France have taken draconian, unpopular steps to tackle the problem, but the United States so far is avoiding the issue. The Republicans are babbling on about cutting the deficit and reducing the debt, but, when asked where specific cuts can be made, offer nothing. The Democrats indicate they may understand the problem better, but, on the eve of the midterm elections, they cite the danger of cutting government expenditures when the economy is in recession, even though economists claim it isn’t….

There may be reason to believe that after the U.S. elections next week, the Obama administration and Congress, whatever its coloration may be by that time, will address the American version of this pressing problem. Tempting though it may be for Washington’s leadership to pretend otherwise, a $1 trillion-plus deficit and a soaring $13 trillion debt simply cannot be ignored.

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It is a very scary picture.

Pundits are restless, an election looms ”“ so this week, President Barack Obama is proposing yet another round of special favors, aimed at improving the economy. Prominent columnist Paul Krugman wants the plans to be “bold” and to involve huge amounts of money. Here’s a contrasting view: government should stop declaring recovery plans, bold or otherwise.

Maybe the constant announcing of new plans ”“ especially plans backed by borrowing or tax cuts ”“ is, itself, an impediment to economic growth.

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It increasingly seems as if the policy makers attending like physicians to the American economy are peering into their medical kits and coming up empty, their arsenal of pharmaceuticals largely exhausted and the few that remain deemed too experimental or laden with risky side effects. The patient ”” who started in critical care ”” was showing signs of improvement in the convalescent ward earlier this year, but has since deteriorated. The doctors cannot agree on a diagnosis, let alone administer an antidote with confidence.

This is where the Great Recession has taken the world’s largest economy, to a Great Ambiguity over what lies ahead, and what can be done now. Economists debate the benefits of previous policy prescriptions, but in the political realm a rare consensus has emerged: The future is now so colored in red ink that running up the debt seems politically risky in the months before the Congressional elections, even in the name of creating jobs and generating economic growth. The result is that Democrats and Republicans have foresworn virtually any course that involves spending serious money.

The growing impression of a weakening economy combined with a dearth of policy options has reinvigorated concerns that the United States risks sinking into the sort of economic stagnation that captured Japan during its so-called Lost Decade in the 1990s.

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One problem that dogged Japan during its lost decade was a stop-and-go fiscal policy in which stimulus packages were administered in an “on again, off again” fashion and taxes were lowered and then raised. There is a risk that the U.S. could fall into this trap in an effort to strike a balance between short-term fiscal support and long-term budget integrity.

This strongly suggests that congressional leaders of both parties should embrace a pro-growth fiscal reform that would help to create long-run fiscal stability and foster certainty about future tax rates. With the 2001-2003 tax cuts set to expire at the end of 2010, the time is now to move ahead with broad-based reform.

A good starting point would be the bipartisan Wyden-Gregg tax reform bill. This bill is not incredibly bold, but is probably the best we could do in the current environment and is much better than the current tax code.

Wyden-Gregg would be revenue-neutral; it would simplify the tax code by reducing the number of personal income tax brackets to three from six and would do so without raising marginal income tax rates.

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Underpinning the gloom: Nearly two-thirds of Americans believe the economy has yet to hit bottom, a sharply higher percentage than the 53% who felt that way in January.

The sour national mood appears all-encompassing and is dragging down ratings for the GOP too, suggesting voters above all are disenchanted with the political establishment in Washington. Just 24% express positive feelings about the Republican Party, a new low in the 21-year history of the Journal’s survey. Democrats are only slightly more popular, but also near an all-time low.

The results likely foreshadow a poor showing in November’s mid-term for Democrats, whose leaders had hoped the public would grow more optimistic about the economy and, as a result, more supportive of the party agenda. Now, despite the weak Republican numbers, the survey shows frustrated voters on the left are less interested than impassioned voters on the right to in the election.

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… applying the brakes to runaway federal spending will not be easy. As the first reaction to [Defense Secretary Robert] Gates’s announcement showed, whatever their proclaimed ideology, local politicians will squeal when their constituents feel the budget ax.

Among the first to challenge Gates’s decision to eliminate the Virginia-based military command was Virginia Gov. Robert McDonnell, a Republican who has not hesitated to trim spending proposals by his Democratic predecessors.

He was joined by the state’s two Democratic senators, Mark Warner and Jim Webb, who talk a good game of budgetary responsibility but squirm when it hits home.

Obama may have thought it was tough work to push Congress into spending all that he wanted for economic stimulus, education and other causes close to his heart. He is about to learn that nudging the lawmakers to trim the budget may be even tougher.

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In 1995, the federal government, led by the Liberal Party, passed the most important budget in three generations. Federal spending was reduced almost 10% over two years and federal employment was slashed 14%. By 1998, the federal government was in surplus and reducing the nearly $650 billion national debt. Provincial governments similarly focused on eliminating deficits by paring spending and reducing debt, and then they started to offer tax relief.

All government spending peaked at 53% of Canadian GDP in 1992 and fell steadily to just under 40% by 2008. (Government spending in the U.S. was 38.8% of GDP that year.) The recession has caused government spending to increase in both countries. But if present trends continue, within two or three years Canada will have a smaller government as a share of its economy than the U.S.

Canadian taxes have also come down at the federal and provincial level. They were reduced with the stated goal of improving incentives for work effort, savings, investment and entrepreneurship.

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This year, the U.S. public debt is projected to reach 62 percent of the economy””up from 40 percent in 2008 and nearly double the historical average, according to recent Congressional Budget Office (CBO) estimates. The financial crisis and recession drove much of this debt swing, yet larger problems loom in the future.

By 2030, the CBO projects that debt will more than double to 146 percent of GDP.[1] The only good news, if it can be called that, is that the U.S. is not alone. Two recent studies by the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) highlight the significance of the global debt challenge and stress the need for governments to aim higher than short-term deficit reductions. For the U.S., one of the most poorly positioned countries, addressing the long-term debt challenge must include prompt reform of Social Security, Medicare, and Medicaid.

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While the support to economic activity from stimulative fiscal policies and firms’ restocking of their inventories will diminish over time, rising demand from households and businesses should help sustain growth. In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions. In the business sector, investment in equipment and software has been increasing rapidly, in part as a result of the deferral of capital outlays during the downturn and the need of many businesses to replace aging equipment. At the same time, rising U.S. exports, reflecting the expansion of the global economy and the recovery of world trade, have helped foster growth in the U.S. manufacturing sector.

To be sure, notable restraints on the recovery persist. The housing market has remained weak, with the overhang of vacant or foreclosed houses weighing on home prices and new construction. Similarly, poor economic fundamentals and tight credit are holding back investment in nonresidential structures, such as office buildings, hotels, and shopping malls.

Importantly, the slow recovery in the labor market and the attendant uncertainty about job prospects are weighing on household confidence and spending….

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More specifically, the new policy doctrines have caused four great deformations of the national economy, and modern Republicans have turned a blind eye to each one.

The first of these started when the Nixon administration defaulted on American obligations under the 1944 Bretton Woods agreement to balance our accounts with the world. Now, since we have lived beyond our means as a nation for nearly 40 years, our cumulative current-account deficit ”” the combined shortfall on our trade in goods, services and income ”” has reached nearly $8 trillion. That’s borrowed prosperity on an epic scale….

The second unhappy change in the American economy has been the extraordinary growth of our public debt. In 1970 it was just 40 percent of gross domestic product, or about $425 billion. When it reaches $18 trillion, it will be 40 times greater than in 1970. This debt explosion has resulted not from big spending by the Democrats, but instead the Republican Party’s embrace, about three decades ago, of the insidious doctrine that deficits don’t matter if they result from tax cuts.

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When budget experts take our debt’s temperature, the statistic they rely on is the debt to GDP ratio. Like banks or families, richer countries can borrow more, safely.

Now take a look at the graph of debt-to-GDP throughout American history below. If you draw a straight line across the picture at 30 percent, you touch some of the most wrenching periods in American history: 1) The American Revolution; 2) The Civil War; 3) WWI; 4) The Great Depression and WWII; 5) The early 1980s recession and the end of the Cold War…

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