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Is America headed over the fiscal cliff?

3Qs with University Distinguished Professor of Economics William Dickens
December 4th, 2012

The so-​​called “fiscal cliff” facing America refers to the esti­mated $700 bil­lion in total spending cuts and tax hikes for next year alone and is set to take effect in Jan­uary with the onset of sev­eral fac­tors. These include the expi­ra­tion of the Bush-​​era tax cuts, the expi­ra­tion of unem­ploy­ment ben­e­fits and mas­sive cuts in domestic and defense spending trig­gered by the Budget Con­trol Act of 2011 fol­lowing a polit­ical deal on the debt-​​ceiling crisis. Ever since, politi­cians have yet to come to a com­pro­mise on a budget deal in order to avoid falling off the cliff.

Last week, House Speaker John Boehner declared that there had been “no sub­stan­tive progress” on a new deal, though Repub­li­cans on Tuesday coun­tered Pres­i­dent Obama’s latest pro­posal. Here, William Dickens, Uni­ver­sity Dis­tin­guished Pro­fessor of Eco­nomics and Social Policy, explains what steps the gov­ern­ment must take to pre­vent the U.S. from going over the fiscal cliff.

Why has the fiscal cliff reached this point and what are the most likely scenarios in which America will address the problem?

The fiscal cliff was con­structed as a solu­tion to the debt-​​ceiling crisis in the summer of 2011. Leg­is­la­tion was passed imposing the Jan­uary 2013 dead­line for a full solu­tion to the budget prob­lems or auto­matic budget cuts would go into effect. This will coin­cide with the ending of the Bush tax cuts, the reduc­tion to social secu­rity pay­roll taxes and extended fed­eral unem­ploy­ment ben­e­fits. The idea was to make it so onerous not to have a budget deal that the Democ­rats and Repub­li­cans would be forced to com­pro­mise. But it seems it may not have been onerous enough. Many people are now con­cerned that a deal can’t be cut because the two sides have been at log­ger­heads for so long and because there isn’t enough time to com­plete a deal given how com­pli­cated it is to change the country’s tax codes and spending plans.

Looking for­ward, one sce­nario involves doing the near impos­sible: to com­plete a budget deal in a month, when it would nor­mally take many months and when there still isn’t even agree­ment on the basic prin­ci­ples of a deal. The second would be to kick the can down the road to pro­vide more time to come up with a com­pro­mise, but, again, there would still need to be agree­ment on core prin­ci­ples. The third out­come is going off the cliff; when all the con­trac­tionary changes hit in Jan­uary we can expect the economy to slow and even go back into reces­sion if a deal isn’t reached soon after the first. On top of that, we’d be facing another fight over raising the debt ceiling and with that, the pos­si­bility of a fed­eral gov­ern­ment shut­down of some form because it wouldn’t be able to borrow the money it needs to operate.

Which option do you think is most likely?

I think we’re going over the cliff. I’m not cer­tain of it, but I’d say it’s more likely than not at this point.

The economy has been improving, and we could have expected rapid growth next year if it were not for the threat of these fiscal fits. The housing market is finally coming alive. That was the big drag on the economy for sev­eral years. If we go over the cliff, I’d guess we’d push our­selves back into a reces­sion, though not a severe reces­sion. The Con­gres­sional Budget Office fore­casts a rel­a­tively small decline in GDP over the next year if the spending cuts and tax increases go into effect.. But the danger is that this could be another Lehman Brothers moment that could upset the finan­cial mar­kets. The U.S. could be seen as not being able to govern itself and this might scare people off from buying our bonds. With insta­bility in the finan­cial mar­kets, there’s always the pos­si­bility of a panic like we saw in 2008, which could lead to another depression.

This issue has no doubt been politically charged. President Obama has railed against Republicans for their opposition to tax hikes, while the GOP has criticized the administration for not proposing specifics on spending cuts. Politics aside, what steps are necessary to begin fixing this mess?

Any rea­son­able solu­tion to the budget deficit requires both cut­ting spending and raising taxes. There’s no get­ting around it, unless you want to rad­i­cally trans­form Amer­ican society, which I doubt most people want. In par­tic­ular, it makes sense to con­cen­trate tax increases at the top of the scale. Those rates have come down enor­mously over the last 30 years, while in that time inequality in pretax earn­ings has grown. Pretax earn­ings for the very well off have grown con­sid­er­ably rel­a­tive to others, while top income tax rates have fallen from the 90 per­cent rates that pre­vailed in the 1950s and 1960s to 35 per­cent on earned income today.

On the other hand, some­thing must be done to con­tain med­ical expenses. That’s the really big problem with our country’s expen­di­tures. Nei­ther party will want to do this by itself. There must be some across the board agree­ment, which will likely be unpop­ular. That could include increases in taxes that pay for Medicare and Social Secu­rity and hard ceil­ings on the amount of money spent on those pro­grams. If we’re going to have a health­care system that’s sub­stan­tially funded by the fed­eral gov­ern­ment, then there needs to be limits on how much the gov­ern­ment has to spend on that program.

by Matt Collette


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