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Fiscal Cliff Notes

November 13, 2012

3-minute read

The US federal budget is back in the spotlight now that the election is over. In one sense, not much has changed in that the Republicans continue to hold the House, the Democrats the Senate and White House. But what we are now witnessing is the culmination of budget deals going back to the first Bush II administration, right up to last year's "debt ceiling" debacle. There is a lot on the table, and what we see over the coming weeks and months will be a classic left-right battle over the role of government in modern society. The US continues to struggle with the job of building a modern state that includes robust social infrastructure for health care, education and retirement.

First, it is important to note that "fiscal cliff" is a terrible metaphor. There is no cliff per se; the Economic Policy Institute instead calls it an "obstacle course" to come up with a package of tax and spending measures – aka a budget, though the US has not had a real budget in a few years – in a manner that does not throw the economy back into recession. In spite of the hyperbole, it is interesting that the framing of this issue is anti-austerity, a recognition that the status quo would dramatically undercut demand. Altogether, tax increases and spending cuts scheduled to come into effect automatically as of January 1 could wipe out up to 4 percent of US GDP in 2013.

Thus concern over the "fiscal cliff", hyperbole aside, suggests that lessons have been learned from Europe where austerity has become a morality play with demands that public sector cuts are needed in the name of shared pain and sacrifice so that the gods of business investment once again look favourably upon the economy. That reversion to classical economics has failed horribly, as witnessed by double-digit unemployment across Europe but particularly acute in areas further from the German centre of power, like Spain, Italy and Greece.

[As an aside, we can only hope Canada is paying attention too, and the federal government will formally abandon its balanced budget ambitions for 2015. Plus, how the US budget negotiations play out will clearly have an impact on the Canadian economy given how much we export to the US.]

In terms of the left-right battle, there are two big items that could shape the future of the US federal government, both the result of bi-partisan budget compromises: the Bush tax cuts, and the Obama debt ceiling deal. W could only pass his tax cut package, which is heavily weighted toward upper-income tax cuts, in a Democrat-controlled Congress by making them temporary. They were extended to the end of 2012 in the 2010 stimulus bill, but post-election they should be allowed to expire, especially given the huge surge in inequality in the US (the top 1% captured 93% of the income gains in the recovery thus far) and the successful framing of Romney as a billionaire disconnected with ordinary folk. Letting the Bush tax cuts expire would restore top marginal income tax rate in the US to 39.6%, last seen during the Clinton administration, from 35% (though applying only to incomes over about $388,000), and would similarly restore the Estate tax, both of which are worth a lot in budget dollars but with negligible economic impact.

While the Republicans will certainly try to make the Bush tax cuts permanent, they will also try to impose cuts to Medicare and Social Security. The Budget Control Act, which resulted from the GOP's 2011 "debt ceiling" manoevre, imposes across-the-board spending cuts (known as "sequestration"). In theory this could also include cuts to the military, which seems unlikely, so this could mean things like increasing the retirement age for Social Security and imposition of caps on health care coverage. It's hard to say if that would actually happen, since a big part of the GOP base benefits from those "entitlements" their party loves to deride, but the Tea Party is nothing if not ideologically opposed to the public sector.

Aside from those core issues are a number of temporary measures brought in as part of the 2009 and 2010 stimulus bills, which also expire at year-end. Some of these are pork, such as breaks to the oil and gas industry and subsidies to "farmers" (technically, big corporate agri-business), while others are useful and should be continued during the recovery, including the payroll tax cut, extensions of unemployment insurance, and various refundable tax credits that benefit low to middle-income households.

A key thing to remember is that most of the US federal deficit is due to the recession. The danger is that the US cuts its deficit too quickly, undermining the soft recovery under way. Medium-term, spending is only a problem to the extent that the US cannot get its act together on revenues. The US needs to have an adult conversation on taxes to pay for necessary public services and infrastructure (the latter will be under even more pressure after Hurricane Sandy's devastation).

So, the "fiscal cliff" is mostly budget hysteria, although there are some substantive economic issues about the role of government. Expect much political theatre as Obama negotiates with Congress on a "grand bargain" and hope that he can dig his heels in on upper-income tax increases and maintaining social programs.

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