By V. Gunaratnam, November 23, 2012
The US “fiscal cliff” is what will happen if hundreds of billions of dollars in tax hikes and spending cuts in the US start to take effect in the New Year, driving the economy into recession. More precisely, it is the challenge the US government will face at the end of 2012, when the Budget Control Act of 2011 takes effect, mandating large automatic spending cuts and tax increases, and reduces the proposed increase to future government spending, beginning in 2013.
It is important to the large mass of peoples who populate the world, because any problem faced by the US economy would have a pervasive effect on the rest of the economies of the world, whether we are Americans, English, Greeks, Tamils, Indians, or Chinese, to mention just a few of them.
Unless an agreement is reached to change the terms of the Budget Control Act, the US economy will metaphorical fall off the fiscal cliff, and into recession, unable to absorb the shock of the massive deficit in a $600 billion mix of automatic tax increases and spending cuts beginning in 2013. The economic problems created by this will spread and engulf many of the major economies on the planet.
Ways to intervene and avert the “fiscal cliff”
Seasoned Washington observers say not to freak out because they think there will be no deadlock, as lawmakers will be thinking about their own fate first, if blocking a deal leads to the collapse of the economy that leaves people suffering, and it rebounds on them at re-election time.
There are three principal ways lawmakers can intervene to modify the terms of the Budget Control Act, with their consequences, remembering also that doing nothing also counts as an intervention.
1. Free-falling: There is no intervention here. If the President and Congress fail to reach agreement on debt reduction, the US economy will metaphorical plunge off the cliff in a $600 billion mix of automatic cuts at the end of the year. The Congressional Budget Office (CBO) estimates this will shrink the GDP by 4% in 2013, and send the economy into a recession, the likelihood of a partial government shutdown, and spread uncertainty at home and abroad.
2. Temporary step-back: In this scenario the Congress and the Senate delay extending most tax breaks, and hold back a lot of the spending cuts in 2013. It will mean loss of revenue that will add to the deficit, and the US debt will continue to grow. But the administration will be able to continue until 2016, after which they would be forced to deal with the deficit. The tax increases and spending cuts will slash the US deficit by a projected $503 billion. But it will also shrink the economy by 0.5%, and probably cost millions of jobs. It could also lead to a European style crisis.
3. Cliff-hanger: If, as anticipated, a last minute deal is reached, preserving many, but not all of the mandatory spending cuts and tax increases, it will result in a weak 2013 growth, but avoids a recession. The CBO estimates if Congress takes the middle ground by extending the Bush tax cuts, and canceling the automatic spending cuts, the result in the short term, may lead to modest growth, but hardly any major economic benefit.
It is absolutely necessary to reflect on the underpinnings of a solution, how the GDP is affected by spending cuts and tax breaks for a long term solution to be fashioned for strong economic recovery.
CBO estimates that the effect per dollar is greater for spending cuts than tax increases.
– A one dollar tax increase results in the GDP going down by half a dollar.
– A one dollar cut in spending results in the GDP going down by one dollar.
However, absolute size matters. CBO estimates the spending cuts will reduce GDP by 0.8%; the end of the payroll tax holiday will reduce GDP by 0.7%; the end of the Bush tax cuts for the rich will reduce GDP by 1.4%; the and the end of the middle-class tax cuts would shrink the GDP about 1.3%. It is clear that extending the Bush tax cuts to the middle-class, but letting the tax cuts on the rich to expire, would have virtually no impact on growth.
Falling off the cliff or the gradual way
If the financial impact of the fiscal cliff is spread out, it is not going to be so painful. In fact, the impact will be minimal. Look at how the Fiscal-staircase way accomplishes this.
Free-falling way: This is the falling off the cliff way. Assume that all of the $600 billion in tax increases and spending cuts automatically take effect on January 1. It is a 4% hit on GDP, a huge and unacceptable decline. Now consider the other option.
Fiscal-staircase way: On January 1, spending cuts and tax increases of about $1.6 billion take effect; on January 2, another $1.6 billion; on January 3, another $1.6 billion, and so on. This is not a falling-off the cliff scenario, but a gradual, an almost painless step by step transition, giving lawmakers time to make a sound economic deal.
Can a compromise be reached?
There are many variables to consider and therefore so many ways of dealing with the fiscal cliff.
But the lawmakers pose the greatest difficulty to a deal being reached. There is so much partisanship between the parties, and fierce political rivalry. But they have to come together in the national interest, overcome their doctrinaire inclinations, and philosophical differences, and make a deal. Bear in mind also that Obama’s win also suggests he enjoys the confidence of the people.
As one observer said, “Even the lamest of ducks can pass legislation averting the short-term fiscal crunch.” There is a strong belief this is what is going to happen, buying time for a comprehensive deal later on.
Harry Reid, Senate Majority Leader, has said he and Boehner had a “pleasant conversation” ahead of both parties meeting to discuss the issues. And for his part, House Speaker John Boehner has offered to make peace with President Obama, offering to work together to create a sound economy.
Perhaps the germs of a solution are buried in their words. Everyone accepts that a revenue component is required to tackle the fiscal cliff, not just a trimming of the spending budgets. This could be a starting point for discussions. The revenue increases could only come from tax increases and cost reductions.
Some ideas worth considering
1. One suggestion is to aim a bit lower, instead of trying to come up with the almost unreal $4 trillion cuts, when half that amount could stabilize the debt over the next decade.
2. Medicare and Medicaid, and not social security, are the biggest driver of the US debt. This prompted one commentator to say “We don’t have a deficit problem; we have a health care spending problem.” US lawmakers will want to look at this remembering there are disadvantaged in society.
3. This an extreme solution. President Obama just vetoes any deal put forward by Congress. The US hits the fiscal cliff in the New Year. Taxes go up to the high Clinton era rates, military and other spending dear to the Republicans get slashed, and they are forced to negotiate a new deal before the changes become permanent. At some point, Congress retaliates by refusing to raise the debt ceiling causing economic chaos.
4. The Fiscal-staircase way suggests that there will be no falling off the fiscal cliff to worry about. However, it cannot go on for long, and deal must be made for a robust economic recovery.
5. But if no deal is made the GDP will shrink, the economy will slow down, unemployment will increase sharply, and the result will be devastating. It will be politically unacceptable to both.
6. The Bush tax cuts for the rich will be a stumbling block, and spending cuts to defense will be another hurdle to be cleared with the Republicans.
The obvious thing to do is to implement a short-term solution and postpone a long-term deal to a later time, giving the lawmakers time for reflection to find common ground for a solution that makes sound economic sense.
Everything will be thrown into the ring, principally tax increases for the rich and tax cuts for the middle class, and spending cuts to defense, elimination of payroll tax, and so on, to produce the trillions of dollars of deficit reduction that would magically lift the US out of its economic crisis.
New Debt Ceiling
The debt ceiling will need to be raised early next year, like in 2011 when the Budget Control Act was enacted. Probably another face off will be played out by the lawmakers, before an agreement is reached to raise the debt ceiling.
The reader might also do well to note that in its most recent report by the Congressional Budget Office (CBO), a federal agency within the legislative branch of the US government that provides economic data to Congress, it says:
If the various current tax and spending policies are allowed to expire as scheduled under current law “growth in real terms would be just 0.5%, with the economy projected to contract at an annual rate of 1.3% in the first half of 2013 and expand at an annual rate of 2.3% in the second half…such a contraction in the first half of 2013 would be a recession.”
In the longer term, the years ahead, the CBO says: “However, eliminating or reducing the fiscal restraint scheduled to occur under current law next year without imposing comparable restraint in future years would reduce output and income in the longer run relative to what would occur if the scheduled fiscal restraint remained in place.”