Now that the election has ended, the media narrative has turned to the next major problem: the Fiscal Cliff. But, what exactly is this scary sounding doomsday machine? In this next installment of Election 101, we get some help and explain why we should all be paying attention to this developing story.
Forbes does a wonderful job of summarizing all of the pertinent information about the fiscal cliff, so we will be using much of their article, “A Guide to Understanding the Fiscal Cliff”
1. What is the Fiscal Cliff?
Barring any Congressional action, a series of tax increases and spending cuts will begin Jan. 1. Observers have named that series of monetary policy actions as the fiscal cliff because it would send a shock through the U.S. economy. A number of tax cuts would expire, including several that lower income and payroll taxes and limit the alternative minimum tax. Some 90% of Americans would see their taxes rise. Just as significantly, large amounts would be slashed from the government budget. This would, for example, reduce spending on defense and lower some government benefits.
Sources: Congressional Budget Office; Tax Policy Center: Toppling Off The Fiscal Cliff: Whose Taxes Rise And How?
2. How did we get here?
In August 2011, Congress passed the Budget Control Act. This temporarily raised the nation’s debt limit by $2.1 trillion. The legislation mandated that Congress reach a more long-term solution; if not, then the law calls for that collection of tax increases and spending cuts to start after running through that $2.1 trillion—this happens in December. Thus, the current situation.
Moreover, the act lowered the projected funding for many government organizations by $1 trillion and ordered the Supercommittee to find another $1.2 trillion to cut.
Source: Center On Budget And Policy Priorities
3. How indebted is the US?
The broad goal behind the fiscal cliff is to make the United States’ debt level more reasonable. Right now, the country’s debt-to-GDP ratio is 70%, the highest level in more than 70 years. By contrast, that’s slightly lower than Germany’s debt/GDP ratio of 81%, and more than double Greece’s ratio of 163%. Economists have generally concluded that when a country reaches a debt/GDP ratio of more than 90% or 100%, economic growth is constrained.
Why? A more indebted country faces greater borrowing costs, and it reduces the flexibility to respond to unexpected situations. It also raises the odds that investors could, eventually, lose confidence in the government’s ability to manage its budget, sparking another financial crisis.
Sources: CBO; European Commission: European Economic Forecast, Spring 2012; International Monetary Fund’s World Economic Outlook: Coping With High Debt and Sluggish Growth
4. What happens if Congress fails and we fall off the Fiscal Cliff?
t would be bitter medicine. A recession would begin in the first half of 2013, reducing U.S. economic growth by about 0.5%. Unemployment would increase. The jobless rate would rise to 9.1% by Dec. 2013 from 7.9% today.
Yet, it would somewhat cure the country. The budget deficit would fall to $200 billion by 2022 from $1.1 trillion today; debt/GDP would fall to 58%.
5. More specifically, what happens to business?
Already, anxiety among business owners is growing. The expiring tax cuts, many of which directly affect businesses, would restrain investment and hiring. (An Ernst & Young report estimates 2.4% less investment and 710,000 fewer jobs.) Another perspective: Consider that 75% of all small businesses, the key drivers of the U.S. labor market, are organized as pass-through entities. This set-up means those owners pay their business income at the individual rates. Those tax rates are set to rise. The lowest tax rate would go to 15% from 10%. The rest: 28% from 25%; 31% from 28%; 36% from 33% and 39.6% from 35%.
Source: U.S. Chamber of Commerce Small Business Outlook Survey (Q3 2012); National Federation of Independent Businesses
6. Can we do nothing?
No. By 2022, the U.S. would hit that key level of a debt/GDP ratio of 90% within a decade.
7. What can we do?
The U.S. must either cut the dollars given entitlement programs or increase taxes. Alternatively, a combination of those would work. Striking that balance between spending cuts and tax hikes, of course, is what currently bedevils Washington, D.C.
Health care programs and social security will be foremost on the chopping block. Both represent tens of billions in potential cuts. Meantime, there is equal opportunity to make a difference with tax hikes, such as increasing the maximum taxable earnings under the Social Security payroll tax.
8. What has been done so far?
The decision on this issue has twice been kicked down the road: first in August 2011, then the following November. Negotiations waited to ramp up until the election finished. President Obama’s victory and the reelection of a Democratic Senate and Republican House necessitate a bipartisan agreement. So far, Obama has invited Congressional leaders to open talks at the White House, but both parties have staked out say territory: Obama, while saying he’s not wedded to all of his suggestion, is strongly in favor of raising taxes on the wealthiest Americans; Republicans, under the leadership of House Speaker John Boehner, strongly oppose this, arguing it would stall business growth.
Source: (Forbes) Market Isn’t Sold On Obama’s Olive Branch For Fiscal Cliff