America is failing to face up to the truth behind its looming fiscal cliff

Mark Littlewood
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AMERICA, we are told, is a nation divided. But this wasn’t the closest presidential election in recent times. Far from it. Barack Obama won both the popular vote by a reasonable margin and stormed the electoral college. Obama’s fellow Democrats also rebuffed their opponents in races for the Senate. The only consolation for the Republicans is that the House of Representatives remains firmly under their control, and they now hold a substantial majority of governors in US states.

But this now means that two unhappy terms will begin to dominate the debate in America: deadlock and the fiscal cliff. Politicians on both sides of the aisle now face a looming deadline over the credit-worthiness of their nation. If Republicans and Democrats can’t reach agreement by the end of the year, a $607bn (£379.8bn) package of spending cuts and tax rises will come into effect on 2 January 2013. Called the fiscal cliff, it’s the result of failure by the US Congress in 2011 to reach agreement on how to reduce the federal deficit.

According to the US-based Tax Policy Centre, if the situation isn’t resolved, taxes will rise by $500bn in 2013, as almost every tax cut enacted since 2001 will expire. Average tax rates will rise by 5 per cent on labour income, by 7 per cent on capital gains, and by more than 20 per cent on dividends. Middle-income Americans face an average tax increase of almost $2,000.

Some forecasters suggest that this could reduce US GDP by around 5 per cent and cause unemployment to rise to nearly 10 per cent, the latter being a staggering statistic in historical terms. And the old adage is that if America sneezes, Britain catches a cold. If this is in anyway true, prepare yourselves for a severe and lengthy bout of influenza.

More likely than not – because it usually does – the Washington establishment will patch together some sort of deal to fend off such a scenario in the short term. But only in the short term.

This is why the term deadlock will dominate so many headlines in the coming weeks. Rarely have America’s two political parties been so ideologically divided. The Republicans endorse substantial reductions in spending and a swift move to reduce taxes. The Democrats are determined to retain and even extend big government programmes, and to hike the tax burden on the affluent in an attempt to pay for them. There is now virtually no overlap between the two parties.

This doesn’t mean a deal can’t be patched together. But it does mean it will be very awkward and incoherent. It will amount to little more than buying some time because substantial structural reform of tax and spend simply isn’t going to happen in the US over the next few years.

Part of the problem is that, in this election, America did not face up to the problems that loom behind the fiscal cliff. Mitt Romney’s running mate, Paul Ryan, had diligently worked on a sensible, but largely unambitious, attempt to begin to get government spending under some sort of control. Called the Path to Prosperity, those presently reliant on certain state benefits would generally operate under existing rules, but over the medium term state-financed health support would be opened up to market choice.

But Ryan’s proposals never quite managed to form the centrepiece of the Republican proposition. Politicians are rarely rewarded for being the bearer of bad news, even if they are saying things which need to be said. It’s like a scene from the film A Few Good Men. Tom Cruise asks for the truth and Jack Nicholson shouts back “You can’t handle the truth”. Ryan must feel the same way about the American electorate.

In a democracy, the people are free to vote for candidates who are opposed to the law of gravity. But this doesn’t make Newtonian physics any less true, nor does it mean a pause button can be invoked to temporarily stop big objects falling to the ground.

The Republicans and Democrats may be able to patch together a compromise and once again postpone the implications of the US’s inability to live within its means. But the problems will persist. In America, expect this fiscal cliff-hanger to last for several years to come.

Mark Littlewood is director general of the Institute for Economic Affairs.