The Fiscal Cliff: Catastrophe Or Logical Consequence?

Image courtesy of Talk Radio News Service

Throughout the summer of 2011 the looming debt ceiling crisis was a hot topic in the American media, until a temporary agreement headed off presumed disaster and media outlets switched their focus to the Republican Primary. With the 2012 election cycle (finally) over, another economic event is making news across the country–the much-hyped “fiscal cliff.” Many mistakenly assumed that the fiscal cliff was just another name for the debt ceiling. Although tangentially related, they are two completely different entities. In order to decide whether to fear the cliff or face it with a sort of stoic acceptance, we must first understand what it’s really all about.

 

Ben Bernanke, Federal Reserve Chairman. Image courtesy of Ondrej Kloucek

The phrase “fiscal cliff” was created by Ben Bernanke, chairman of the Federal Reserve, to describe a series of deals that lead to more than $500 billion in tax increases and across-the-board spending cuts scheduled to take effect after Jan. 1 unless President Obama and Republican lawmakers reach an alternative resolution. When we talk about tax increases, what does that mean exactly? To be technical, we aren’t directly raising taxes. We are allowing $400 billion in tax cuts to expire on December 31. Of course, if the tax cuts cease to exist, taxes paid will necessarily increase. Several separate cuts will expire, snowballing together to account for the $400 billion. Of these, the ones familiar to most Americans are the “Bush-era Tax Cuts”, which President Obama has elected to extend in the past but which will expire this year. In addition, smaller tax cuts that periodically expire for businesses and individuals will go away, as will the 2-percentage-point cut in payroll taxes President Obama pushed for in 2010, which increased an average worker’s take-home pay by about $1,000 a year. In addition roughly one in five American taxpayers will have to pay the alternative minimum tax for 2012, which will increase their tax bill. This is the result of Congress failing to pass the inflation adjustment they usually pass, which typically limits the taxpayers subject to the alternative minimum largely to the highest echelon of income earners.

Photo courtesy of Voices Empower with Alice Linahan.

Spending cuts-wanted by some, feared by others.

That explains the tax increases, but what about the spending cuts? An emergency unemployment-compensation program is due to expire, which saves $26 billion but also stops payments for millions of who have exhausted state unemployment benefits. However the largest spending cut would be $65 billion in across-the-board cuts for most federal programs over the last nine months of fiscal year 2013. Social Security, Medicaid, military pay and veteran’s benefits are shielded from any cuts; the cuts would come from reducing spending in federal agencies and cabinet departments.

Referred to as the sequester, and touched upon during the Presidential debates, these sweeping cuts were put into motion by an August 2011 budget deal between the President and Congress that ended weeks of heated debate over the impending debt limit crisis–as I mentioned, the debt limit is connected to the fiscal cliff. Through the Budget Control Act of 2011, as the deal was named, the parties agreed to cut spending by $1 trillion over 10 years and to identify $1.2 trillion in additional savings by January 2013, in exchange for allowing the debt ceiling to be raised. If the two sides cannot agree on alternative cuts to be made–and as of yet they have not–the predetermined cuts will kick in automatically.

The Budget Control Act of 2011 was created to serve as a compromise in the debt ceiling dispute. Looking at the agreement, it seems clear that those calling for higher taxes got far more in the bargain than did those looking for spending cuts. The year-over-year changes for fiscal years 2012—2013 include a 19.63% increase in tax revenue and 0.25% reduction in spending. While these changes bring the tax revenue back to its historical average of 18% GDP, the spending level continues to stay at the level it has been since 2009.

This diagram from the Congressional Budget Office shows how federal debt would decrease if we go over the “fiscal cliff,” but would increase if we reinstate current policies to avoid the cliff.

While some are playing the role of Chicken Little, warning Americans that the sky will indeed fall if we go over this so-called cliff, others are jumping at the chance to roar defiantly over the cliff, Thelma-and-Louise-style. Who is right? It depends on whether you think short-term or long-term. The Congressional Budget Office has stated it believes America will have an increased risk of a recession during 2013 if the tax increases and spending cuts are allowed to happen simultaneously and instantaneously. However, the Budget Office also states that the resulting lower deficits and decreased debt would improve the long-term economic growth for our nation. Basically, we are looking at a temporary mild recession in exchange for nearly $600 billion in savings starting next year.

Of course, those pushing for tax increases do not want to see across-the-board spending cuts. Those pushing for spending cuts do not wish to see across-the-board tax increases. With both sides so firmly entrenched, it is hard to predict what could happen. Then again, as one strategist remarked on the Sunday morning media circuit, this situation didn’t happen by accident. Much of it was put into place intentionally as part of the debt ceiling compromise back in 2011. The proverbial chickens have come home to roost, and it is fair to ask why they should not be allowed to do so, as agreed upon. Of course, complicated situations in Washington often lead to more complications, which is the case here. Coincidentally, and somehow unforeseen by the President and lawmakers arguing over the fiscal cliff, the aforementioned debt ceiling has begun rearing its ugly head, as its limit may once again be reached by–you guessed it–January 2013.