A lot of people, including Federal Reserve Chairman Ben Bernanke, are worried that we are nearing the edge of a fiscal cliff. I’m more concerned with the hole we are already in.
The “fiscal cliff” refers to the scheduled expiration of a slew of tax laws – most notably the “Bush-era” tax cuts, which have already been extended well into the Obama era, and the “one-year” reduction in employee FICA taxes, which is now in its second year. Combined with the automatic spending reductions also set to take effect Jan. 1, the changes would drain up to $700 billion from the economy. In testimony before Congress, Bernanke warned that, if all the changes go into effect, the economy will respond with shock, contraction and possibly a new recession.
Adding to the concern, the Treasury is also now approaching the debt ceiling that Congress authorised last summer, in the compromise that also created the automatic spending scheduled to take effect at the end of 2012. We are likely to bump up against the new ceiling right around the same time that the end-of-the-year changes come into effect.
I am not particularly worried about the fiscal cliff, however, because we are unlikely to tumble over the edge.
We have been down this road before. The Bush-era tax cuts were originally due to expire at the end of 2010. President Obama wanted to let the cuts lapse for high earners. Republicans refused. At that time, Democrats controlled not only the White House, but both houses of Congress as well. They could not get exactly what they wanted, because Senate Republicans had enough votes to block a partial extension of the tax cuts; Democrats could only extend the tax cuts for everybody or for nobody. We ended up with a two-year extension for everybody.
With Republicans in control of the House of Representatives this year, the choice is exactly the same, and I fully expect to see the same result.
If Obama is re-elected, he will not be in any better bargaining position next year than he is now. Republicans are still almost certain to control the House, and they will be near parity with Democrats in the Senate. Obama has shown that he will continue the status quo rather than allow taxes to rise for everyone in those circumstances. So we’ll be back to where we were in late 2010.
If Mitt Romney wins in November, a lame-duck Obama might refuse to extend the tax cuts for high-income Americans this fall. Republicans will, in that case, just wait him out. Romney will be sworn into office on Jan. 20, and Congress will pass a quick and retroactive extension of the tax cuts. There are enough Senate Democrats siding with Republicans on this issue to ensure this result. At least seven Democratic senators have already said they are willing to consider a temporary extension.
The automatic spending cuts are a new variable; we were not in this position in 2010. But they won’t happen either, at least in their current form, because neither party wants them. Republican fiscal conservatives will still demand big cuts in return for another debt ceiling extension, but the cuts will probably be somewhat smaller, and differently arrayed, than the ones scheduled to take effect automatically. The parameters will likely be decided as part of the next battle over the debt ceiling.
So we are not going to tumble over the fiscal cliff. That certainly does not mean we have a smooth fiscal path in front of us. We are in a deep national financial hole, and it gets deeper the longer we ignore the fundamental fact that our short- and long-term spending plans are unsupportable at any tax load that the U.S. private sector is able to sustain. We cannot borrow and spend our way to durable prosperity. We’ve been trying for at least four years now – arguably a lot longer – and we have succeeded only in digging a larger pit.
From here, it’s possible to see the bottom and get a pretty good idea of what it will look like. Other countries, notably China, will inevitably start to doubt our capacity to return their money. First they will raise our interest rates. If we have not made serious changes to our fiscal policy at that point, the higher interest rates will simply add to our budget deficits, forcing us to borrow more and more money, paying ever higher prices to get it. If we reach the very bottom of the hole, investors will stop lending to the U.S. Treasury altogether.
The way out of this hole isn’t easy. At this point, a merely balanced budget will not be enough; we need a surplus in order to begin to pay down our debt before rising interest rates make it unsustainable. We need to get serious about increasing revenues and reducing spending. The issue goes far beyond whether or not to maintain the Bush-era tax cuts on high earners.
As I have written before, it is not feasible in the long run for the majority of Americans to be net recipients of tax dollars. The top 1 per cent of earners is now responsible for about 40 per cent of the country’s tax load, while nearly half of Americans pay no federal income taxes at all. Converting more citizens into taxpayers would help fix the problem, not merely by raising more money, but also by making more of the electorate – and this should be everyone who is not truly poor – weigh the costs of government services and benefits against the burdens imposed on the private sector that must bear those costs.
The good news is that we are not about to go over the fiscal cliff. The bad news is that this is because it’s hard to fall off a cliff when you are already in a hole.
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