Understanding the US fiscal cliff debate and the global economy

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By Omoh Gabriel with agency reports

THE subprime mortgage financial crisis started as an issue in the United States of America early in 2007. By 2008 it had blossomed into a global financial crisis. Whenever the US economy sneezes, the global economy shivers. Today, it is the fiscal cliff that is causing yet a stare in the global economy. With the Euro zone in sovereign debt problem, and its spill over effects on the world economy, a fiscally induced recession in the US will be a cause for worry to all concerned.

In the United States, the Congressional Budget office has projected the US deficit up to 2022. The US fiscal cliff is a term referring to the effect of a number of laws which, if unchanged, could result in tax increases, spending cuts, and a corresponding reduction in the budget deficit beginning January next year. Budget deficit as it is known in economic parlance is the difference between what the government takes in and what it spends. The US government has run on huge deficit over a long time.

The Congress in attempt to ensure that government does not borrow ad infinitum decided that that the US should undergo voluntary deficit reduction. The deficit part of the US budget is expected to be reduced by roughly half next year beginning from January. That sharp reduction in the US deficit budget is the cliff that has now gained global attention. The United States Congressional Budget Office (CBO) believes that the sudden reduction the deficit and eventually government spending will probably lead to a recession in early 2013 with the pace of economic activity picking up after 2013.

Danger for the world economy
A recession at this time that the Euro zone is in crisis portends danger for the world economy given that the US is the largest economy. Nigeria will be very vulnerable if this happens. In the US the laws leading to the fiscal cliff over the years include tax increases due to the expiration of the Bush tax cuts and spending cuts under the Budget Control Act of 2011. The Budget Control Act of 2011 was enacted due to the failure of the 111th Congress to pass a Federal Budget and therefore as a compromise to resolve a dispute concerning the public debt ceiling.

Prior to President Obama re-election US deficit spending previously appropriated by Congress was bringing the US federal government’s total debt close to the statutory ceiling. In 2011 Republicans members in the US Congress refused to approve an increase in the ceiling unless there were deep spending cuts in order to come closer to a balanced budget and reduce the amount of national debt that was accruing.

The Budget Control Act included an immediate increase in the debt ceiling, along with a mechanism for facilitating two additional increases. It also provided for automatic spending cuts to begin on January 2, 2013. According to the provision of the legislation the year-over-year projected changes for fiscal years 2012–2013 include a 19.63 per cent increase in tax revenue and 0.25 per cent reduction in spending.

These changes would return tax revenue to approximately its historical average of 18 per cent of US Gross Domestic Product, GDP, while continuing to spend at dollar levels held approximately the same since 2009. Some major programmes, like Social Security, Medicaid, federal pay (including military pay and pensions), and veterans’ benefits, are exempted from the spending cuts. Spending for federal agencies and cabinet departments would be reduced through broad, shallow cuts referred to as budget sequestration.

The reason for reducing deficits is to reduce the growth of the United States public debt. The argument is that although the debt would continue to grow, over the next ten years projected increases in the debt would be lowered by as much as $7.1 trillion or about 70 per cent, resulting in a considerably lower ratio of debt relative to the size of the economy.

However, because of the short-term impact on the economy, including a possible recession, these changes stirred intense commentary both inside and outside of Congress and have led to calls to extend some or all of the tax cuts, and to replace the across-the-board reductions with more targeted cutbacks.

President Barack Obama of the United States

Additionally, the debate may be exacerbated by the expectation that the debt ceiling is expected to be reached before the end of 2012, unless “extraordinary measures” are used. Nearly all proposals to avoid the fiscal cliff involve extending certain parts of the 2010 Tax Relief Act or changing the 2011 Budget Control Act or both, thus making the deficit larger by reducing taxes and/or increasing spending.

The genesis: The term fiscal cliff, according to Wikipedia, had in the past been used to refer to various fiscal issues. The term started being used in the current context near the original expiration of the Bush tax cuts in 2010. In 2011, the term started to be used to refer to the deficit reductions that would occur in 2013 under current law.

In late February 2012, Ben Bernanke, chairman of the U.S. Federal Reserve, popularized the term “fiscal cliff” for this crisis. Before the House Financial Services Committee he described that “a massive fiscal cliff of large spending cuts and tax increases” would take place on January 1, 2013. International media report indicate that some analysts have argued that fiscal slope or fiscal hill would be more appropriate terminology because while the cumulative economic effect over all of 2013 would be substantial, it would not be felt immediately but rather gradually as the weeks and months went by.

Legislative history: According to USA Today and other media report on the issue “During a lame duck session in December 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010”. The act extended the Bush tax cuts for an additional two years and “patched” the exemptions to the Alternative Minimum Tax for tax year 2011.

This act also authorized a one-year reduction in the Social Security (FICA) employee payroll tax. This was extended for an additional year by the Middle Class Tax Relief and Job Creation Act of 2012, which also extended federal unemployment benefits and the freeze on Medicare physician payments. On August 2, 2011, Congress passed the Budget Control Act of 2011 as part of an agreement to resolve the debt-ceiling crisis.

What the new Obama administration is faced with beginning from January is the fact that the Act provided for a Joint Select Committee on Deficit Reduction (the “super committee”) to produce legislation by late November that would decrease the deficit by $1.2 trillion over ten years.

If the committee failed to do so, as it in fact had failed to do, another part of the Act directs automatic across-the-board cuts (known as “sequestrations”), split evenly between defence and domestic spending, beginning January 2, 2013. Also, the Affordable Care Act imposed new taxes on families making more than $250,000 a year ($200,000 for individuals) starting at the same time.

Key laws leading to the fiscal cliff: US legislative history shows that a number of laws led to the fiscal cliff, including among others: Expiration of the Bush tax cuts extended by President Obama in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010; Across-the-board spending cuts (“sequestration”) to most discretionary programmes as directed by the Budget Control Act of 2011; Reversion of the Alternative Minimum Tax thresholds to their 2000 tax year levels; Expiration of measures delaying the Medicare Sustainable Growth Rate from going into effect (the “doc fix”), as extended by the Middle Class Tax Relief and Job Creation Act of 2012 (MCTRJCA); Expiration of the two per cent Social Security payroll tax cut, most recently extended by MCTRJCA; Expiration of federal unemployment benefits, as extended by MCTRJCA and New taxes imposed by the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010.

Very tough financial time
From all indications the Obama administration will face a very tough financial time without a deal with congress for a new legislation. These provisions would automatically go into effect on January 1 or 2, 2013, except for the Alternative Minimum Tax growth, which would be changed retroactively.

Some provisions would increase taxes (the expiration of the Bush and FICA payroll tax cuts and the new Affordable Care tax and AMT thresholds) while others would reduce spending (sequestration, expiration of unemployment benefits and implementation of the Medicare SGR).

Proposals to avoid the fiscal cliff involve repealing legislation containing certain of these provisions or passing new legislation to extend provisions that are due to expire. Different proposals may include changes to some or all of the above provisions. For example, the Congressional Budget Office’s “Alternative Fiscal Scenario” includes only the first four items above. Changes to other provisions are also sometimes included in such proposals.

Congressional Budget Office projections: Decisions regarding the fiscal cliff will have meaningful implications for deficits, debt, and economic growth. The Congressional Budget Office (CBO) has projected two fiscal scenarios for the years 2013 to 2022. There is what they term the baseline projection. This scenario would have lower deficits and debt but also have lower spending and higher taxes. The second alternative fiscal scenario is higher deficits and debt but lower taxes and higher spending.

These paint starkly different fiscal futures. If Congress and the President do not act, allowing tax cuts to expire and mandated spending cuts to be implemented, the next decade will more closely resemble the baseline projection. If they act to extend current policies, keeping lower tax rates in place and postponing or preventing the spending cuts, the next decade will more closely resemble the alternate fiscal scenario.

Under “the baseline”, tax cuts are allowed to expire and spending cuts are implemented in 2013, resulting in higher tax revenues plus lower spending, deficits, debt and interest for the next decade and beyond.

Future deficit
Future deficits would be reduced from an estimated 8.5 per cent of GDP in 2011 to 1.2 per cent by 2021. Revenues would rise towards 24 per cent GDP, versus the historical average 18 per cent GDP. The total deficit reduction or debt avoidance over ten years could be as high as $7.1 trillion, versus the $10–11 trillion debt increases if current policies are extended.

In other words, roughly 70 per cent of debt increases projected over the next 10 years could be avoided by allowing laws on the books during 2012 to be implemented. CBO estimates under the baseline projection that public debt rises from 69 per cent GDP in 2011 to 84 per cent by 2035. In the long run, lower deficits and debt should lead to relatively higher growth estimates. But, in the short run, real GDP growth in 2013 would likely be reduced to 0.5 per cent from 1.1 per cent.

This would mean a high probability of recession (a 1.3 per cent GDP contraction) during the first half of the year followed by 2.3 per cent growth in the second half. If Congress “avoids” the fiscal cliff, the future more closely resembles the continuation of 2012 policies, described by the CBO’s “alternative fiscal scenario.”

This scenario involves extending the Bush income tax cuts, restricting the reach of the AMT, and keeping Medicare reimbursement rates at the current level (the so-called “doc fix”, versus declining by one-third as mandated under current law).

Revenues are assumed to remain around the historical average 18 per cent GDP. Under this scenario, public debt rises from 69 per cent GDP in 2011 to 100 per cent by 2021 and approaches 190 per cent by 2035. This scenario has considerably higher debt and interest payments than the baseline projection, but short-term impact on the economy is avoided.

Projected effects: The Congressional Budget Office estimates that allowing certain laws on the books during 2012 to expire or take effect in 2013 (the baseline scenario) would cut the 2013 deficit approximately in half and significantly reduce the trajectory of future deficits and debt increases for the next decade and beyond.

However, the 2013 deficit reduction would adversely impact the economy in the short-run. Whichever way the US congress and the President chose to follow will be seen in the next few weeks.

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