The issues and events that brought us to the current street farce involving President Barack Obama and the U.S. House date well before Federal Reserve Chairman Ben Bernanke coined the phrase “fiscal cliff” in February.
So one might assume the public understands pretty well the choices we face. But emails I get and TV news interviews with random people on the street show that isn’t the case. So going over the basic issues may be useful.
Start with Bernanke’s phrase. The word “fiscal” means that the issue deals with taxes and federal spending. That is pretty straightforward. The “cliff” part is more complicated, since some argue that it is more of a slope than a cliff.
I think the Fed chairman chose the term because when one drives over a cliff, a state of apparent stability abruptly turns to a terrifying free-fall that ends in destruction. The suddenness of the change is what he wished to emphasize.
This abruptness results from the fact that, by law, several things will happen on Jan. 1 that might harm the economy.
First, and most contentious, the tax cuts passed a decade ago during the George W. Bush administration will expire and all personal income tax rates will revert to those in place from 1994 through 2000. This would mean an increase in the marginal rate for anyone with enough income to owe tax.
The lowest rate on taxable income would rise from 10 percent to 15 percent. The highest, which currently kicks in at $388,350 for a married couple filing jointly, would increase from 35 percent to 39.6 percent. More important for many high-income people, the preferential rate on capital gains would rise from 15 percent to 20 percent and that on dividends from 15 percent to whatever rate is due on income from wages, salaries or self-employment.
Additionally, the Alternative Minimum Tax would apply to many more payers, and the federal estate tax would revert to the rates and exclusions in effect before 2001.
The second element in the cliff is sequestration. Because Congress and the president were unable to agree in 2011 on a budget for the next fiscal year, a stop-gap bill created a “super-committee” to identify spending cuts for the next 10 years. Since this committee failed, a set of automatic spending cuts would take effect on Jan. 1.
These often are described as “across the board,” but they do not apply to key categories including interest on the national debt and Social Security, Medicare, veterans benefits or as military and civil service pay. The cuts would apply to defense, most means-tested income transfer programs and nearly every other federal spending program, including farm subsidies.
The third major element, and the one that will affect the most households, is the expiration of the temporary 2 percentage- point reduction in Social Security taxes that has been in effect for two years. Unlike income tax rates, which apply only after various deductions and exclusions, this applies to every dollar of wages, salaries and self-employment income up to the cutoff at $110,100.
Taken together, these tax increases and spending cuts will reduce the annual federal deficit by between $600 billion and $700 billion. Given that we ran a budget deficit of $1,089 billion in fiscal year 2012, some may wonder if this isn’t this a good thing.
The answer is no, because cuts in government spending and increases in taxes, all other things being equal, slow output of goods and services, better known as gross domestic product. Slower GDP growth means less national income and hence less household income, less consumer spending and less demand for things sold by businesses. It means fewer people working.
In other words, we would move from an awfully sluggish economy with high unemployment to to one that was actually shrinking and had even higher unemployment, a true recession. That is why Bernanke used the word “cliff.” If you go off a cliff you get smashed up.
The reason for urgency, from the point of view of most economists, is avoiding this return to recession. Perennial large budget deficits and resulting increases in the national debt are a problem, but there is nothing about them that will be much worse in July or December 2013, than they were in July or December 2012.
Unlike similar budget deadlocks in recent years, a failure to agree will not result in inaction, in no change in the status quo. Instead, sharp changes will take place automatically. And while they won’t push the nation into a recession in a matter of weeks, with January unemployment sharply higher than December’s, they will slow the economy in a way that hurts many households.
There are many related questions:
Is the predicted outcome of a recession one made by all economists, or only those who follow the ideas of John Maynard Keynes, who argued governments could counteract recessions and inflations by varying taxing and spending?
Do cuts in spending have the same slowing effects as increases in taxes? How much do marginal tax rates, especially on income from capital, really affect growth of output and employment? What are the relative effects of increasing tax revenue by abolishing deductions, like those for mortgage interest expense, versus raising marginal tax rates? If we really do need to cut spending, what are the effects of cutting in different areas? How do various tax or spending changes affect the rich, the poor and the middle class?
Each of these is complicated, but I will explore them in subsequent columns in the next few weeks.