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Near-term disaster averted, long-term problems remainNegotiations over the so-called “fiscal cliff went down to the last possible moment before congressionalpolicymakers finally approved legislation that voided sizable tax increases and spending cuts that wouldalmost certainly have tipped the economy into recession.
The Senate passed a compromise bill at 2 am on1 January, just after the 31 December deadline passed for the expiration of Bush-era income tax cuts andfor the imposition of USD 110bn in across-the board spending cuts required by the Budget Control Act of2011. The House approved the Senate’s bill, but only after some debate that delayed the vote until 11 pmon 1 January.
Scheduled income tax increases for most taxpayers were cancelled. Various business tax breaks that werescheduled to expire were instead extended for another year. The Alternative Minimum Tax threshold wasraised and permanently indexed to inflation, thus avoiding an exceptionally large tax hike. In contrast, thetemporary reduction in the payroll tax rate will expire as scheduled, with the rate moving back up to 6.2%from 4.2%. However, emergency unemployment benefits, which were also scheduled to expire, willinstead be extended for another year.
Various tax breaks for low-income families were extended for fiveyears. Scheduled across-the-board spending cuts totalling USD 110bn were postponed for two months togive legislators more time to negotiate alternatives for long-term spending reduction.
The policymakers in Washington were pulled in different directions by conflicting imperatives. The firstwas to prevent a sudden shift in federal taxation and spending that would disrupt household and businessfinances and potentially cause a recession in the near-term. The second was to improve the longer-termfinancial outlook for the federal government itself by lowering projected deficits over the ten-year budgethorizon.
According to the Congressional Budget Office (CBO), annual federal deficits are likely toaverage close to USD1.0trn a year for the next ten years, or about 5.0% of GDP. Deficits of thatmagnitude would take the ratio of federal debt to GDP from the current 72% to 90% by 2022. A debtratio that high could inhibit the economy’s growth by pushing up interest rates, thereby crowding outprivate borrowing and capital formation.
As is often the case, short-term considerations won out over longer-term priorities. The AmericanTaxpayer Relief Act of 2012 just passed by the Congress avoids most of the short-term pain that wouldhave been imposed on the economy with higher taxes and spending cuts, but it does little to solve thelonger-term deficit problems.
In a way, this is not surprising. The benefits of long-term deficit reduction,i.e. lower interest rates and faster economic growth, are off in the future and if they do occur, thosebenefits will be enjoyed by politicians in future Congresses, not the current one. Meanwhile, politicians inthe current Congress that will suffer the ire of voters if they raise taxes or cut spending on populargovernment programs such as Social Security and Medicare.
The situation might be different if current fiscal deficits were contributing to high interest rates or to highinflation. Then the majority of voters might demand that Congress act to lower deficits and correct thesituation. The Congress would then be seen as attempting to solve near-term economic problems andmight be rewarded for it. However, interest rates are currently at record-low levels and inflation hasaveraged only about 2.0% for the past five years, well below its previous 30-year average of 4.2%. Sincepressing economic problems are not linked to the deficit, policymakers are apt to give greaterweight toshort-term economic considerations than to solving longer-term economic problems.
