Originally published in The Financial Times October 24, 2012
The US is unlikely to avoid "fiscal cliff"
By MARTIN FELDSTEIN
The United States is rapidly approaching the "fiscal cliff," a dangerous
combination of increased taxes and decreased government spending scheduled
for January 1 that would reduce the budget deficit by five percent of GDP
between 2012 and 2013. Although reducing America's budget deficit is
necessary, such a sharp cut now while the economy is still very weak would
be a serious mistake.
If the fiscal cliff is not avoided or rapidly reversed, the American
economy would soon be in a new recession with substantially higher
unemployment. That would have a negative impact on the global economy.
There is nothing that the Federal Reserve could do to prevent such a
renewed economic downturn.
So just what is the "fiscal cliff," why is it scheduled to happen now, and
what can be done to prevent it?
The biggest piece of the "fiscal cliff" is the automatic expiration of the
tax rate cuts enacted when George W Bush was president. They were scheduled
to end in 2012 in order to limit the official projected revenue loss.
Subsequent legislation provided additional tax cuts that will also end this
year. Expiration would involve higher taxes on personal incomes, on
estates, on corporate profits, and on payroll earnings.
Going over the fiscal cliff also includes cuts in government spending
half in defense and half in non-defense "discretionary" programmes (i.e.,
all programmes excluding Social Security and Medicare). This "sequester"
will automatically start with $109bn of spending cuts in 2013. Over nine
years it will lead to total cuts of $1.2tn unless Congress enacts a
different multi-year budget plan that reduces the deficit by $1.2tn over
those years.
The fiscal cliff can only be avoided by legislation passed by both houses
of Congress and signed by the President. The critical issue that prevents
such legislation is a conflict over tax rates between President Obama and
Republicans in the Senate and House of Representatives. President Obama
wants to extend the current tax rates for taxpayers with incomes below
$250,000 but to raise taxes for those with incomes above that level to the
higher rates that prevailed before the Bush tax cuts. The Republicans want
to extend the current tax rates for everyone and can use their majority in
the House to prevent the Obama plan from becoming law.
The conflict is important economically as well as politically. Although the
high-income group represents only about three percent of all taxpayers,
they pay more than 40 percent of all personal income taxes.
The election on November 6 will determine how the issue of the cliff is
resolved. Although the Republicans will retain control of the House of
Representatives, the outcome is uncertain for the Senate and for the
presidency.
If Romney is elected and the Republicans win a majority in the Senate, the
conflict over tax rates will not persist after the president's inauguration
in January. Even if President Obama were to block Republican-sponsored
legislation to eliminate or postpone the fiscal cliff in the two months
after the election when he is still president, the new Republican
administration and Congress would rapidly reverse the automatic tax
increases once Romney takes office. Doing so retroactively to January 1
would avoid most of the adverse short-run effect of going over the cliff.
Postponing final legislation until mid-summer would give time to craft
compromise reforms of taxes and entitlements that would have a positive
effect on the economy.
If Romney is elected but fails to carry the Senate, a stalemate could
remain. A bipartisan group in the Senate is working on a plan to postpone
the fiscal cliff, substituting a combination of reforms to taxes and
entitlements that would be a desirable alternative. It is too soon to know
what the prospects are for such a compromise.
If President Obama is re-elected, he would regard that as a mandate to
raise taxes on high income taxpayers. Since the Republicans will still
control the House, he may not be able to enact such a tax bill before the
end of the year. Some Democrats advocate that the President allow the
current tax law to expire and then propose new legislation in January to
cut taxes on everyone with income below $250,000, daring House Republicans
to vote against a bill that lowers taxes on 97 percent of taxpayers while
raising taxes on no one. That same legislation could avoid triggering the
sequester if it also broadens the tax base and cuts government spending.
But avoiding the adverse effects of the fiscal cliff under any of the
scenarios would still not deal with America's long run fiscal problems. The
United States needs to slow the growth of the middle-class retiree programs
and raise revenue by limiting tax expenditures in a framework of
fundamental tax reform. Dealing with the fiscal cliff is just the first act
of a play with many acts.
Received on Thu Oct 25 2012 - 09:41:03 EDT
