Obama: Small steps on deficits

NEW YORK (CNNMoney.com) -- President Obama walked a financial tightrope in his State of the Union address on Wednesday.

Faced with an unexpectedly high unemployment rate, he talked at length about the need to spur job growth and help ease the financial strains on the middle class through tax credits, targeted spending and other measures.

But he made one thing very clear: He also wants to address the unsustainable growth rate in U.S. debt.

"[I]f we do not take meaningful steps to rein in our debt, it could damage our markets, increase the cost of borrowing, and jeopardize our recovery - all of which could have an even worse effect on our job growth and family incomes," the president said.

Indeed, the Congressional Budget Office reminded policymakers this week that the U.S. government's fiscal outlook is "daunting."

Here's why: The interest on the debt and unfunded promises to future retirees in Medicare and Social Security are on track to consume an ever-increasing share of the federal budget. And that depletes resources for many of the basic functions Americans expect their government to provide.

To begin to tackle the problem, the president said he would create a bipartisan fiscal commission by executive order.

The commission would make recommendations to Congress for how to address the looming fiscal shortfalls. Deficit hawks have said such a commission should be allowed to put all spending and tax breaks on the table for consideration.

"This can't be one of those Washington gimmicks that lets us pretend we solved a problem," the president said. "The commission will have to provide a specific set of solutions by a certain deadline."

Nevertheless, Obama's panel is a weaker version of a commission that was voted down by the Senate on Tuesday because Congress won't be required by law to consider the presidential commission's recommendations or to vote on them.

And beyond the fiscal commission, many of the president's deficit-reduction proposals were baby budget steps.

It's not that they'll be easy to accomplish given how deeply partisan lawmakers have become. But the actual savings achieved from the proposals relative to the accrued debt is very small.

Spending freeze: The president proposed a three-year freeze on non-defense discretionary spending, which accounts for $447 billion, or roughly 13%, of the 2010 federal budget. The freeze would start next year, he said, when the economy is stronger.

The estimated total savings from the freeze: $250 billion over 10 years. But that's a fraction of the $9 trillion in debt the CBO projects the country could incur over the same time period.

"I think it is a small step," CBO chief Douglas Elmendorf told lawmakers on Wednesday. He added that there is no single step that can adequately balance the budget.

Pay for new policies: Obama has also thrown his support behind the push for statutory pay-go rules. Those rules would legally require lawmakers to pay for proposed tax cuts or spending increases by raising taxes or reducing spending elsewhere in the budget.

Pay-go rules don't actually reduce the debt load already accrued, but they put the brake on future increases in the debt load, which is helpful first step, budget experts say.

The effectiveness of pay-go rules, however, depends on their parameters. The strongest form would not allow any policy to be exempt.

But the president has backed a proposal that would only apply to "any new non-emergency tax cut or mandatory spending expansion," according to a White House statement.

The problem: That would exempt Obama proposals that are not deemed "new" -- for instance, the permanent extension of the 2001 and 2003 tax cuts for most Americans -- which is estimated to cost federal coffers more than $2 trillion over 10 years.

Curbing some tax cuts: The president also reiterated some pledges he has made before but that have yet to be passed by Congress. He favors, for instance, taxing the portion of profits paid to managers of hedge funds and private equity funds as ordinary income rather than as a capital gain. That would subject it to much higher tax rates than the 15% capital gains rate currently imposed. Such a provision is estimated to raise roughly $24 billion over 10 years.

Any credible long-term solution to the country's fast-growing debt puts Obama in a tight political spot.

That's because it would have to involve a combination of tax increases (sure to rankle Republicans) and spending cuts (certain to disturb Democrats).

To use just one would be economically prohibitive.

Just how prohibitive?

Suppose Obama and Congress wanted to rely solely on individual income tax increases to get annual deficits down to 3% of GDP by 2015. If they just raised taxes on high-income households -- something Obama has promised -- they'd have to more than double the top two tax rates.

And that would push the top rate above 75%, according to research by the Tax Policy Center.

If they relied only on spending cuts, they would have to slash the federal budget to the bone. That means they would have to cut much of the discretionary spending pot, including defense.

Elmendorf noted that lawmakers often object in general to "wasteful" discretionary spending.

But when it comes to the specifics, individual programs have fierce defenders, he said. It is after all the pot that pays for everything from public schools, safe roads, health research, national parks, veteran benefits and the court system. To name a few.