Last month's federal debt ratings downgrade by S&P gave the U.S. a black eye and triggered the market Panic of '11. It hurt states and localities in the capital markets as some bonds have been down-rated and as investors become even more jittery. The lost confidence in America's ability to control its own financial destiny has left global stock markets and pension funds reeling with losses and uncertainty that only worsen our financial plight. States and localities will suffer as long as Washington puts politics ahead of fiscal discipline.

But that's just the tip of the iceberg. The picture is actually bleaker than S&P's tiny — yet disputed — downgrade suggests. Our nation's long-term structural deficits are rapidly approaching a tipping point. It doesn't matter whose numbers you study, the projections all lead to the same place if Congress fails to intervene soon: Using 2010 Congressional Budget Office data, in just 14 years Uncle Sam runs out of money for everything but entitlement programs (Social Security, Medicare and Medicaid) and interest on our debt. That leaves nothing for national defense, let alone domestic spending.

It gets worse. Without huge cutbacks in defense spending, Congress will have no money left for anything else by 2020! In this context, one should ask why the other major ratings services have not already joined S&P in its downgrade. If states or cities could forecast only enough money in 2020 to pay their pensions, retiree medical benefits, their public safety workers, and bond interest with no net principal repayments, then nobody in their right mind would rate them AAA — even if their debt is guaranteed by the authority to tax.

Just to keep this straight, the GAO data as compiled by former Comptroller General David Walker show us that by 2020 there will be virtually no money for any of the following departments of the U.S. government unless Congress acts decisively to stem the tide of red ink:

  • Housing and Urban Development
  • Education
  • Transportation
  • Interior
  • Energy
  • Labor
  • Commerce
  • Agriculture

So much for domestic programs that most readers have known all their adult lives. According to the latest catalog of domestic assistance programs, there are 2,182 of them. To appreciate the magnitude of this problem, if defense, entitlements and revenues are unchanged, Congress would have to begin closing one program every business day for 10 years to complete the job in an orderly fashion. Or to put our dilemma into context another way, America's international adversaries don't need to do anything but wait 10 more years and then take us on. As Secretary of State Hillary Clinton has already averred, this deficit quagmire will quickly come to the point of undermining our national security in the next decade. Chinese hardliners have become more vocal about expressing their distrust of our currency and our bonds — as they build a navy to rival ours by 2020 (what a coincidence).

It's time for financial analysts to show politicians and the general public what we must do to put ourselves back on the track to a consensus AAA bond rating and a sustainable budget. History has shown it's not an easy or painless path — but it can be done. Without imposing foolhardy austerity in fragile sectors that would push the economy into recession, a sensible program of long-term budget balancing would immediately restore international confidence that America is back on the path to prosperity.

Otherwise the winners of the next national elections will win a true booby prize — a U.S. economy plunging into Great Depression II. The political bases of both parties, laborers and capitalists alike, will be better off if the President and the select joint Congressional committee act this year, ahead of the next election. They must also broaden the scope of their "solutions" and put everything back on the table with no sacred cows.

On the revenue side, where the White House and Senate liberals prefer to play, the most obvious target will be to cap itemized deductions for taxpayers in the upper income brackets, setting a hard limit at the $100,000 level for Schedule D. This could be phased in over several years to avoid abrupt recession-triggering tax shocks and give taxpayers time to make adjustments in real estate holdings — and even relocate if they wish. A high-level cap on itemized deductions will preserve the mortgage interest deduction for middle-class Americans and raise revenues only from the most affluent. This would target the millionaires and billionaires the President has repeatedly cited, but it won't clobber the moribund real estate and homebuilding industries. Megabillionaire Warren Buffett of Berkshire Hathaway has recently made his case for raising tax rates for the wealthiest Americans who often now pay a lower percentage of income than mainstream Americans because of their various exemptions, deductions, tax incentives and loopholes. The fattest geese to be plucked would be the top-bracket taxpayers in high income-tax states and cities such as California, New York, and Hawaii. Many of those states are Democratic "red states" — so it is fitting that some of the President's wealthiest campaign supporters must take the first hit: Perhaps the time has come for them to put their money where their mouth is. Of course, the amount of revenue this raises is trivial in the context of long-term solvency, but it would balance out the pains from inevitable entitlement reforms (discussed below).

[Update: In the week since this column first appeared, President Obama has proposed that his $447 billion job strategy should be paid for in part by the elimination or reduction of tax exemptions for upper bracket taxpayers and oil companies, similar to the proposals advanced in this column last week. Also, the media recently reported mounting pressure for the Congressional super-committee to find solutions beyond its original $1.5 trillion mandate.]

Expiring Bush tax cuts. In this pre-election Tea Party era, nobody wants to talk about tax-rate increases. Most economists agree that premature tax increases will choke the economy and throw us into a re-run of America's 1937 recession and Japan's 1997 experience — a second plunge in a double-dip downturn that becomes worse than the first. But tax increases are already scheduled for 2013 as the Bush-era tax cuts expire. The White House and congressional Democrats can simply wait out the clock, which strengthens their negative power in Washington — by enabling Democrats even as a minority block to stymie efforts to roll back scheduled tax increases that are already baked into the fiscal forecasts by law. So it's no longer a question of whether or when taxes will rise, it's only a matter of how and in what sequence. Unless they can win a landslide upset in 2012, there is little the Tea Party can do to stop this train. And if they do, they can kiss off any hope of an AAA rating during their stint in office. Without the 2000 tax rates, governors and mayors can likewise kiss off domestic programs because there soon won't be money for them at current tax rates unless we first gut the far more popular entitlement programs.

Keynesian macro-economics has many fallacies and shortcomings, but it did enlighten us that income tax increases for those in the highest bracket will have less impact on consumption and thus GDP than taxes on the less affluent. Keynes' "diminishing marginal propensity to consume" remains axiomatic after 75 years. Therefore, the most sensible way to schedule the unavoidable restoration of pre-Bush tax rates across the board would be to phase them in by starting at the top two brackets first (essentially just the taxable income over $200,000) in 2013, and moving down one bracket each year until all Americans resume paying taxes at 2000 rates in 2016. That should allow enough time for the sluggish economy to regain its footing and give middle- and lower-bracket taxpayers as much time as possible before they also will endure the pain we must impose first on the richest citizens. President Obama must abandon his 2008 campaign pitch to exempt the middle class from inevitable tax increases. That populist strategy will flunk the fiscal reality check after 2013.

A bipartisan compromise to increase the capital gains and dividend tax rates by a third from 15 to 20 percent can raise revenue but still keep the USA competitive in the global capital markets — but that's the practical upper limit. Taxpayer Buffett is also right that commodity speculators and hedge fund operators don't deserve the capital gains benefits their lobbyists have secured them. They should at least pay an alternative minimum tax (AMT) at a new 29 percent rate that focuses on the top 1 percent of incomes while we relieve the mainstream middle class from the convoluted AMT. Congress can do that in conjunction with the rate-reset and the cap on itemized deductions.

These changes in the tax code would eliminate the great uncertainty that now hangs over investors, and make it easier to allocate capital and make business plans. A streamlined business tax code is probably too complicated a task for this year, but certainly will be easier if the largest tax subsidies are addressed in 2011 (discussed below).

For states and localities, the only silver lining in these tax increases is that tax-exempt municipal bonds will become more attractive to wealthy investors as the last major tax haven. Tax-equivalent muni yields in the high-tax states will exceed 9 percent using today's market levels and wealthy investors will gobble them up. As markets normalize, I would expect to see 4 percent plain-vanilla muni bonds return in a restored AAA USA economy, once investors can see that Uncle Sam will not hyper-inflate the economy to repay its increasingly foreign-held debt with a depreciated currency. AAA-rated munis could even trade again in the upper 3 percent range in that environment. That would make infrastructure finance much easier even without federal grants.

Laffer curve revisited. What liberal Democrats must grasp is that the seemingly innocuous tax policies outlined above will result in top-bracket combined tax rates topping 50 percent of earned income for prosperous residents of California and New York City. Anything more than that can only be called confiscatory, and will invite new schemes and high-pressure lobbying to evade those high rates. In those states, the suggested 2013 dividend and capital gains rates will then exceed 32 percent and AMT rates would top 40 percent, when the Medicare surtax is included. Those levels will surely push funds of some investors and traders into tax-haven domiciles where savvy cynics are already shuffling their assets. Supply-sider Arthur Laffer will remind us again of his famous tax curve (where higher rates produce less revenue) and he could be right at marginal levels this high. Capital will find a lower-tax home. To prevent fiscal Armageddon, we clearly need to cut spending for years to come, and that's where the Tea Partiers and traditional Republicans have it right in the long run.

Subsidies under scrutiny. On the spending side, there are at least three prosperous industries already on the chopping block for the subsidy ax: oil, ethanol and agriculture. The president has railed long and hard about tax preferences for oil drillers and the petro trusts, and fuel prices now are sufficiently high to draw out more production. Ethanol subsidies are a waste of taxpayer money in today's global energy markets. They actually distort grain production in the cornfields as Asian demand for protein has pushed grain prices to new levels. With farmers making record profits from high global prices, traditional farm subsidies are obsolete. The USDA can instead provide federal crop insurance programs at minimal cost to taxpayers to aid farmers hit by drought, hail, floods or pestilence. Today's ag subsidies underwrite inefficiently small, subscale farms supported by Uncle Sam, pay farmers to leave land idle, guarantee inflated prices unnecessarily and send huge checks to the big guys who don't need the money to stay in business. Even farmers derisively call it "country and western welfare."

Other, less visible subsidies to specific industries must be reviewed. The fragile housing industry (where sinking home values threaten the banking sector and thus the nation far beyond the interests of homebuilders and realtors) is clearly still off-limits for fiscal reform. Mortgage deductions must remain intact for the majority of taxpayers until fewer homeowners are underwater and the banks holding mortgage paper can recapitalize. But after 2020, housing-related tax breaks could be whittled down with other itemized deductions as we place more emphasis on the virtues of production and savings and less on middle-class housing consumption. Postal subsidies for advertisers should be reviewed along with the entire USPS system in the context of the Internet age and competing delivery systems. Anybody who receives three times more junk mail than stamped letters would agree that commercial access to our USPS mailboxes should be priced higher.

Entitlements back on the table? Contrary to the debt limit deal's "exclusions," entitlement reforms should now be part of the strategy to restore our AAA bond rating. Longevity reforms would show the world the fiscal discipline and political resolve that S&P found lacking when it cut its rating. This means the Social Security retirement age must be raised incrementally so that those born after 1980 must wait to retire at age 69½ with full benefits, instead of 67 (which is now the age for everybody born after 1960). Medicare benefits must immediately begin to align with Social Security's normal retirement age. If Baby Boomers work an extra year or two before becoming Medicare eligible, that will help both systems financially. If Boomers ever hope to assert any semblance of moral authority, they must accept immediate delays in the starting age for retirement benefits in order to right the ship of state. Longevity has increased by five years in the past half-century and it's time we adjusted the systems for this simple fact. This change is mathematically inevitable — how can politicians keep putting off the obvious?

Raising payroll taxes to bail out these programs would be a deathly and stupid fiscal strategy now, as federal income tax rates are already scheduled to jump 10 percent. Medicare taxes are already increasing for investors under the health care reform law (if it stands constitutional muster), so we already have hefty tax increases on the horizon. Piling on to those would almost assuredly trigger the nation's first "FICA recession."

State and local issues. The only municipal losers in these retirement reforms will be those state and local employers that now pay full medical benefits to early retirees. Ultra-generous employers will be on the hook for full costs longer — until the Baby Boomers reach Medicare age — unless they curb their eligibility rules as well. On the other hand, the longer that participating public employees keep working before they file for Social Security and Medicare, the fewer burdens there will be on public pension plans, so the net impact is helpful but unevenly distributed.

More controversial to this readership will be the related issue of state and local government exemptions from Social Security. As I've written before, the historical loophole enjoyed by one-third of municipal employees who don't pay FICA taxes must eventually be closed. A rational approach will begin with new hires, and then begin to tax incumbent employees for their fair share of the national costs of income redistribution that they presently evade.

Getting beyond the rhetoric. Many House Republicans will agonize over the inevitable, pending 2013 tax increases without visible reductions in domestic programs. I would not be surprised to see them demand deeper cuts in spending to match or double the scheduled tax increases. But the burden will be on GOP members of the joint Congressional committee to present a list of specific targets and not just a vague reference to spending cuts. What is most needed at this time is specificity and scale: fraud, waste and abuse slogans have been worn out. It's time to single out the federal programs that cannot be sustained — realizing that the next two years of budget-cutting are just the beginning of a decade-long triage process as the entitlement programs cannibalize the rest of the federal budget (even with the reforms described above). Otherwise, please return to the bullets I listed after the third paragraph. Failure to act soon would inevitably result in elimination of most or all domestic spending programs by the end of this decade.

The political flaw in the remedies outlined above is that they leave the bickering partisans less to quibble about in the 2012 elections. And we sure can't get there if the President now tries to run for re-election as an outsider rather than a problem-solver. Besides the "booby prize" problem cited earlier, what the leaders of both parties must accept is that there is plenty of room left for other policy arguments in next year's campaigns. Further entitlement reforms will be needed beyond simply raising the retirement ages. The Pentagon budget is now up for grabs. The nation is waiting to hear somebody come up with a strategy to create jobs when we can't afford to just borrow more. Tax reform could be debated but minority Republicans would have every right to say "no mas!" to further increases while income tax rates are restored to 2000 levels in 2013-16 as the price of regaining our AAA. The federal role in education deserves a strong debate. Federal regulations are still driving small businesses nuts. The USA needs a genuine energy policy to curb our dependence on imported oil as domestic drillers produce abundant natural gas. There is always privatization of something to argue about. So there are plenty of opportunities for spirited debate. Add to that the usual social rights issues that have few fiscal consequences, and there is plenty to campaign about.

Sacrificial lambs, anyone? If state and local government leaders wish to avoid devastating cuts in discretionary domestic programs they hold dearest, then they must present a united front in support of sensible reforms such as those outlined — along with a short list of what they would be willing to forego as part of a national compact to share sacrifices. Although the traditional first rule of Beltway lobbying is to never gore your own ox, it would be disingenuous to advocate higher federal taxes plus cuts in subsidies to private industries and elders while arguing to spare every state and local aid program. Municipal leaders must decide what's worth saving, and what they can live without. To do so, leaders must look beyond their noses to see which programs are likely to die on the vine inevitably as money runs out to feed the entitlement Pac-Man. For example, if you want to preserve the Social Security FICA tax loophole for state and local employees, you need to suggest $12 billion annually of cuts to intergovernmental assistance. Or stand on the sidelines as Congress does that job for you by default with across-the-board cuts, lower-budget block grants or cost-shifting and -shedding strategies that leave local leaders holding the bag.

Budget officers for states, municipalities and school districts need to begin a thoughtful process to alert their elected officials to the implications of severe federal aid reductions in the coming decade, especially if Congress fails to take meaningful action this fall. To put this in perspective, most states presently fund about 15 to 25 percent of their budgets from federal aid. The Governmental Accounting Standards Board (GASB) has undertaken a project on disclosing intergovernmental fiscal dependency as part of their work on fiscal sustainability, and their timing could not be more prescient. Some GASB critics oppose the inclusion of such forward-looking information in the financial statements, but somebody has to take the reins and lay out the implications of eroding federal assistance. If the budget officers or bond lawyers would rather specify the format for disclosures, that's fine. I know that it's hard enough trying to deal with today's budget problems. Nobody wants to think about a gloomy empty-pockets scenario. But the failure of Washington to get its act together will soon trickle down to everybody else.

Anybody who conducts strategic planning sessions can reprint this article and its embedded links for their advance reading materials.