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S&P's downgrade of U.S. government debt was without doubt an historic event, and for all the obvious reasons, not least of which is that this was unprecedented, and it throws a wrench into every theory of efficient markets. If U.S. debt is not without risk, then where in the world can highly liquid and risk-free investments be found?

Of course, markets knew even before the downgrade that U.S. fiscal policy was on an unsustainable course. The downgrade added nothing to the world's understanding of the increasingly fragile outlook for U.S. finances. It was clear long ago that something had to change, but for years the majority of the politicians of both parties had steadfastly refused to acknowledge the problem.

The greatest impact of the downgrade will be on the future course of U.S. politics, because the downgrade sets the ground rules for next year's elections. The question around which all political discussions will revolve for the next 15 months is this: is the U.S. government's fiscal problem one of too much spending, or insufficient taxation? This election will be about the proper role of government, and that is an issue that is long overdue to take center stage.

To properly set the stage, I offer the chart above. Importantly, I would note that spending as a % of GDP is set to increase significantly absent any attempts to reform entitlement programs, most notably ObamaCare and Social Security. Meanwhile, revenues have been increasing at a 10% annual rate for over a year even as the economy posts only meager growth and tax rates have not risen at all. In my view, the problem is clearly one of too much spending, but this is an issue which needs to be decided by the electorate next year.

If there is any obvious cause of the revenue shortfall that we are experiencing, the above chart points the finger to the weak recovery. Income taxes have fallen more than anything, and this is a direct function of the fact that total employment has fallen by more than 6 million in the past three years, and the unemployment rate is over 9%. Get the economy on a faster growth track, with more people working and paying taxes, and federal revenues will almost certainly boom. The revenue side of our fiscal problem has its roots firmly planted in an anemic recovery.

The solution to our fiscal problem has its roots firmly planted in partisan politics. What is the best way to boost growth and thus solve the revenue side of our fiscal problem? Spend more or tax more? Should spending as a % of GDP increase, or should it decrease? Should government do more or do less?

As a supply sider, I believe that there is no reason to raise tax rates. In fact, I would argue strongly that tax rates should be held steady or reduced, especially corporate taxes. As a student of how the world works, I believe that more government is not the solution to our problems, since government can never be as efficient as the private sector. Less government, especially considering how much it has grown in the past few years, and how much the economy has struggled, is the solution.

But I'm not in charge, and the people will have to decide in November 2012 which direction we should take. The next year or so will be one of the most exciting and eventful times in decades. Let the elections begin!

Source: The Downgrade Will Set the Tone for the Next Election