Q & A – The US Fiscal Cliff (bbc.co.uk)

The US faces a deadline to agree new legislation that could make or break the global economic recovery.

The so-called “fiscal cliff” has been on the horizon for two years, but now the 31 December deadline is almost here.

Now that the presidential election is over it is hoped that policymakers will knuckle down to find a solution.

Why are we here?

President Obama’s administration has been at loggerheads with Congress over the size of the government spending levels and tax rates. Congress refused to raise the US government’s borrowing limit, which is set by statute.

Perversely, other legislation passed by Congress commits the federal government to spending and defines its ability to raise tax revenues, in effect forcing the administration to run the budget deficits that threaten to push it through the statutory borrowing limit.

In a bid to break the stalemate both sides agreed in August 2011 to set up a bi-partisan committee to find ways of capping US government spending over 10 years, plus find another $1.2tn (£758bn) in savings over the period.

The committee set its own ticking timebomb. Fail to reach a deal by 31 December, and automatic spending cuts would be triggered. The committee failed.

What is the fiscal cliff?

On 31 December, a raft of temporary tax cuts is due to expire, just as huge automatic spending cuts are introduced.

The US will be staring over the fiscal – or financial – cliff. Individuals and companies will be hit simultaneously with tax rises and reductions in government contracts, benefits and support.

Some $607bn of cuts and tax rises are planned, including reductions in the defence budget, the end of an employee tax holiday, changes to Medicare allowances and higher personal taxes.

The lower paid will lose some child and income credits, while the long-term unemployed will lose their right to continue drawing benefits.

The political intention behind the cliff is that both sides have too much to lose: Republicans are loath to allow the Bush tax cuts expire or defence spending be slashed; Democrats want to maintain President Obama’s temporary measure to help the unemployed and low income earners, and to avoid deep cuts in non-defence spending.

What are the origins of the crisis?

The roots of the current crisis date back to 2001, when President George W Bush’s administration was trying to pass a programme of tax cuts worth $1.7bn.

Failure to secure the required majority in Congress, meant the measures were pushed through under a rule that would result in the tax cuts expiring in 2011. In 2010, two years after Barack Obama was elected President, a deal was struck with the Republican-controlled Congress to extend the deadline for two years.

Other tax changes and temporary spending measures were added to the legislation, which President Obama hoped would bolster an economy that was sinking into recession and losing jobs at a rapid rate.

Why does it matter?

Analysts have painted a grim picture of the consequences for the world’s largest economy, with some warning that the impact could push the eurozone debt crisis into the shade.

“The US fiscal cliff represents the single biggest near-term threat to a global economic recovery,” the Fitch ratings agency said recently. “The dramatic fiscal tightening implied by the fiscal cliff could tip the US and possibly the global economy into recession. At the very least it would be likely to halve the rate of global growth in 2013.”

The IMF has warned that even the uncertainty raised by the fiscal cliff has hit global investment and job creation. If the US actually fell off the cliff it could knock possibly four percentage points of growth off the US and undermine the fragile confidence in the rest of the world, it said.

President Obama has said he will not compromise on taxes for the rich
How will individuals suffer?

JP Morgan economist Michael Feroli has estimated that more than $550bn could be sucked out of the economy. “In all, the tax increases and spending cuts make up about 3.5% of GDP, with the Bush tax cuts making up about half of that,” he said.

The US-based Tax Policy Center (TPC) estimates that the average annual tax bill for each American would rise by $3,500. The super-rich face an average tax rise of $120,500 a year, while the lowest earners will see an increase of about $412.

For the middle earners – about 60% of the population – the TPC estimates that the average annual tax rise would be about $2,000.

Surely there is scope for compromise?

Some analysts believe the problem is the very notion of a fiscal cliff itself; the idea of an all-or-nothing deadline after which the US economy could be forced into the abyss.

Economists Josh Bivens and Andrew Fieldhouse, in a paper for the Washington-based Economic Policy Institute, say that “fiscal cliff” is a poor metaphor. Policymakers should, instead, be talking of a fiscal obstacle course – a series of separable barriers that should be looked at individually and make compromise easier.

Getting rid of the Bush-era tax cuts for higher income earners (a focus of debate in Washington) would have a negligible impact on economic growth, they argue. Whereas some of the automatic budget cuts would do harm.

“Policymakers and economic commentators should stop talking about the upcoming fiscal cliff and talk more plainly about what is needed,” the two economists say.

“The current path leads to a recession in 2013. We can fall right into, barely avoid it, or sail past it, depending on how nimbly we navigate the fiscal obstacle course”.

Any sign that Congress and the administration are taking this on board?

Republicans seem to be coming around to the need for high income earners to pay more taxes. However, most Republican members of Congress have publicly pledged not to raise taxes.

One way around this dilemma has been proposed by Glenn Hubbard, economic advisor to the failed Mitt Romney presidential campaign, who wrote in the Financial Times that the rich should be made to pay more by closing tax loopholes that they currently benefit from.

President Obama however has claimed that such measures simply wouldn’t raise enough tax to be worthwhile. He continues to insist that the Bush-era tax cuts for the wealthiest 2% must be allowed to expire.

During his reelection campaign, he endorsed the views of billionaire investor and philanthropist Warren Buffett, who called in the New York Times for much higher taxes on those earning more than $1m, and even higher ones for those over $10m.

Mr Buffett was particularly critical of the fact that capital gains tax is much lower than the top rates of income tax, given that the highest earners make a much bigger proportion of their money from gains on investments than from employment income.

Is there a way forward?

It is possible that, now the election is out of the way, policymakers will focus on the impending deadline. But at this moment it is just that – a possibility.

This whole issue has been characterised by brinkmanship, with neither side refusing to blink first.

Shortly after Mr Obama’s re-election, the Treasury Secretary Timothy Geithner spoke out against the idea of extending all the tax cuts (including those on the highest earners) in order to by more time for negotiations, taking the view that a hard deadline was the only way to get a deal done.

The raft of tax and spending changes about to hit America could be altered, postponed or even cancelled. It is a matter of agreeing new legislation.

But although the language on either side has sounded more conciliatory since the elections, the gap between their respective positions remains substantial.