The Fiscal Cliff: Playing Chicken at the Edge of a Precipice

By Terry Colberg

While the election held our attention rapt for the better part of the year, the country has been careening headlong towards a deadline that, if crossed, portends disaster: the fiscal cliff. But how did we get into this frightful mess? And how are our leaders on Capital Hill planning on getting us out of it? Are they planning on getting us out of it? Or are we stuck watching the two political parties speed towards the financial abyss with the rest of us in the back seat?

The fiscal cliff is a disaster of our own creation. It started taking shape with the battle over the debt ceiling in 2011, when the Republicans, who controlled the House, conditioned raising the debt ceiling on immediate spending cuts and other deficit-reduction measures. That summer-long slog culminated in the Budget Control Act of 2011, but left the United States with a downgrade of the nation’s credit rating by Standard & Poor’s. Although the credit downgrade was an indictment of the failure of the federal government’s ability to function, the more telling signal of the breakdown of the political process was the form that the deal on the debt ceiling took: the only solution that Congress found was to abdicate its budgetary responsibility.

The Budget Control Act commissioned the twelve-member Joint Select Committee on Deficit Reduction, known popularly as the “super committee”, and tasked it with the responsibility to reduce the deficit by at least $1.2 trillion over the period of fiscal years 2012 to 2021. By November 23, 2011, a majority of the super committee needed to vote on a budget deal to be submitted to Congress for approval by an up-or-down vote (no amendments or delays allowed) lest automatic spending cuts of $1.2 trillion, split evenly between defense and non-defense discretionary spending, would come into effect after January 1, 2013. The committee, composed of six Democrats and six Republicans, proved to not be so super: the members conceded on November 21, 2011 that they had failed to reach a deal. The countdown to indiscriminate budget cuts had begun.

As 2012 began and the smoke from the previous year’s conflagration began to clear, an even greater crisis appeared in the distance. It was Ben Bernanke, chairman of the Federal Reserve, who warned in testimony before the House Committee on Financial Services on February 29, 2012 that “[u]nder current law, on Jan. 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases.” What Bernanke had seen from his crow’s nest was the shadow of the deadlines and expiration dates at the end of the year that would be waiting after the election for a lame-duck Congress to solve.

Politicians and the attention of the country returned to Washington last month. Automatic spending cuts (also known as sequestration) are set to slash federal spending across the board [1] and the bundle of tax cuts passed under the Bush administration [2] are about to expire (previously discussed by Byron Moore). The Alternative Minimum Tax (“AMT”) needs patching to prevent it from hitting an additional 27 million taxpayers this April (up from about 4 million annually). [3] Unemployment insurance for about 2.1 million people out of work more than six months ends December 29th, with an additional million in the next few months. Medicare payment rates to doctors will get cut significantly unless Congress renews the “doc fix” and various tax incentives will also expire. And the government is about to hit the debt ceiling again—as of December 6th, 2012, the federal government was only $63 billion away from hitting the debt ceiling that had been raised to $16.394 trillion only 17 months prior. The Treasury Department expects to hit the limit in the next couple of weeks and plans to use some accounting sleight-of-hand to ensure the country’s obligations are met through January.

Going over the fiscal cliff would strangle our economic recovery before it left the nursery. The Congressional Budget Office (“CBO”) estimates that the consequence of the contractionary fiscal policy that is a part of current law (not including the effects of a failure to raise the debt limit) will be a slight recession for the next year with unemployment increasing to 9.1% by the fourth quarter of 2013. [4] The pain in the short-run would begin to mend by the middle of the decade as economic growth returned and the debt-to-GDP ratio declined. On the other hand, if Congress changed current law to keep all of the fiscal policies presently in effect, short-run economic growth would transform into stagnation later in the decade as increasing public debt would lead to higher interest rates and limit economic growth. [5] Furthermore, a downturn in the U.S. economy could magnify the ongoing financial struggles the European Union is going through. While it is clear that current deficit levels are unsustainable in the long-run, it is not clear what form these corrective measures must take and whether they are even the most immediate concern.

President Obama’s plan for $2 trillion in deficit reduction (over ten years) is based upon extending the Bush tax cuts for everyone except for income earners in the highest tax bracket (taxes would remain the same for incomes below $200,000 (for single filers) or $250,000 (married couples), but those earning above those amounts would see their taxes increase from 33% and 35% to 36% and 39.6%, respectively). He does not want to tackle reforms for Medicare or Social Security at this juncture.

The Speaker of the House, John Boehner, presented the Republican plan. The GOP wants to keep the Bush tax cuts for all income levels and seeks $2.2 trillion in deficit reduction through the elimination of tax incentives, such as deductions for charitable donations and mortgage interest (specifics are yet to be negotiated), changes in entitlement programs, such as increasing the eligibility age for Medicare and decreasing the cost-of-living adjustments for Social Security, and discretionary spending cuts (also to be negotiated).

Both the President and the Speaker assume as a part of their plans that the AMT will be adjusted and the “doc fix” will be re-implemented. Unlike Speaker Boehner’s plan, the President’s plan includes $200 billion in economic stimulus: infrastructure spending, an extension of unemployment benefits, and an extension of the current payroll tax cuts. [6]

Not all liberals and conservatives, however, are necessarily in agreement with the President and the Speaker that inaction is the most unpalatable outcome. In his column at the New York Times, Paul Krugman [7] cautions against fiscal austerity in the short-run, remarking that pursuing deficit reduction at this time and plunging the economy back into recession would be counter-productive. In his view, a compromise that is a bad deal could be worse than no deal at all. Grover Norquist, [8] on the other hand, does not seem to think that the consequences of the fiscal cliff are that bad at all. Norquist, who has convinced nearly every Republican in Congress to sign a pledge to never vote to raise taxes, sees the automatic spending cuts as a “good idea.” He thinks that taxes are too high, even without the expiration of the Bush tax cuts, but predicts that the Democrats will accept an extension of the tax cuts for every income level, like they did in 2010. Senator Patty Murray (D–WA), the incoming chairwoman for the Senate Budget Committee, sees a potential advantage for Democrats in waiting until after January 1st to make a deal: “‘[a]nything we do will be a tax cut at that point, because taxes will have gone up.’”

The President proposes dealing with the debt ceiling by making the strategy employed to raise the debt ceiling last year under the Budget Control Act permanent. The strategy, called the “McConnell Provision” (named for the person who proposed it last year, Senate Minority Leader Mitch McConnell), would place responsibility on the President to periodically request an increase of the debt limit and Congress would have the opportunity to vote to disapprove the increase. The President could then veto the disapproval, thereby requiring Congress to muster a 2/3rds majority to override the veto and to stop the debt limit increase. This would change Congress’ responsibility from approving every debt limit increase to choosing to block an increase if they disagreed with it.

This is both politically and economically expedient since it brings an end to the automatic crises that occur every time the debt limit approaches and allows fiscal conservatives to vote against the debt limit increase without necessarily blocking it. However, Congressional Republicans have moved to block any such thing from happening—Ohio Senator Rob Portman noted in a letter to the President that “[c]ongressional authority over the limit is ‘necessary to encourage deficit reduction and uphold our constitutional tradition of legislative control over borrowing . . . .’” While it is hoped that a deal on the debt ceiling will be part of an overall package passed before the end of December, Republicans see the limit as a very effective tool at extracting budget cuts and want to be able to use it whenever the debt ceiling needs to be raised.

But as always, what is possible will be limited to what can be wrangled out of the current political crisis. The initial offers from each side have been scoffed at by the other. Although the Democrats control the White House and the Senate, the Republicans control the House—some form of compromise will be necessary in order to get anything passed. Conveniently, because there are so many different pieces in play, there is a lot of room for compromise. But there are so many stakeholders and people with different perspectives on what is an “optimal” solution that figuring out what to do will take quite a bit of effort. President Obama and Speaker Boehner met privately on Sunday (Dec. 9), but appear to remain deadlocked. Even more depressing, the American public does not seem to fully follow what is actually going on. But what they are sure of is that they want politicians to “‘[d]o something that doesn’t affect me.’”

Note: This post is current up to December 10, 2012. Updates on the ongoing fiscal and debt crises will be posted in the coming weeks.

Sources



[1] A report from the Office of Management and Budget predicts those cuts to be a “9.4 percent cut in defense programs and an 8.2 percent reduction in domestic initiatives.”http://www.washingtonpost.com/politics/decision2012/white-house-dire-cuts-for-military-if-congress-fails-to-avoid-fiscal-cliff/2012/09/14/73d796d8-fe90-11e1-b153-218509a954e1_story.html.

[2] Congress temporarily extended the Bush-era tax cuts in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. Several other tax credits renewed in this bill are also set to expire in January. See Public Law 111-312, available at http://www.gpo.gov/fdsys/pkg/PLAW-111publ312/pdf/PLAW-111publ312.pdf.

[3] The Alternative Minimum Tax began in 1969 as a response to some high-income families using tax credits, deductions, and loopholes to avoid owing income taxes. The AMT was not indexed to inflation, causing this parallel tax system to apply to a greater number of families as the years go on. In order to prevent this tax from applying to wide swaths of the middle class, Congress has routinely passed “patches” to raise the income level threshold that triggers the tax. See http://www.npr.org/2012/11/12/164980052/how-the-alternative-minimum-tax-could-slam-you.

[4] GDP growth is expected to be –0.5% for the next four quarters. A recession is two quarters of negative GDP growth. See An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022,http://www.cbo.gov/publication/43539see also Fiscal Tightening in 2013 and Its Economic Consequences – Infographichttp://www.cbo.gov/publication/43544. The New York Times, based on numbers from the CBO, Tax Policy Center, and Moody’s Analytics, predicts that annual GDP growth for 2013 could decline as much as 3.06%. http://www.nytimes.com/interactive/2012/12/05/us/politics/fiscal-cliff-game.html.

[5] The CBO predicts that the debt-to-GDP ratio could approach 90% by 2022 if Congress doesn’t take some measures to reduce the deficit.

[6] The payroll tax cuts were a temporary stimulus measure that reduced the taxes on each paycheck from 6.2% to 4.2%. Payroll taxes pay for Social Security by taxing individuals on their first $110,100 in wages.http://money.cnn.com/2012/12/07/news/economy/payroll-tax-cut/.

[7] Professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University and recipient of the 2008 Nobel Prize for Economics. His blog can be found here: http://krugman.blogs.nytimes.com/.

[8] A conservative activist who founded Americans for Tax Reform.

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