The fiscal cliff looms dangerously over the US presidential campaign

AS THE US presidential election approaches, one issue has been singularly absent from the campaign. And it’s the issue that worries US investors the most. According to a recent survey by Macro Risk Advisors, Americans are increasingly concerned about a looming “fiscal cliff”, over which the US is set to hurtle on 2 January 2013.

The cliff in question is a $607bn (£375.6bn) combination of tax increases and spending cuts, and is the result of failure by the US Congress in 2011 to reach agreement on how to reduce the federal deficit. Without political intervention, it will come into force just as our New Year Eve hangovers start to wear off. But how bad could it be?

According to the Tax Policy Center, taxes would rise by more than $500bn in 2013, as almost every tax cut enacted since 2001 would expire. Average marginal tax rates would rise by 5 per cent on labour income, by 7 per cent on capital gains, and by more than 20 per cent on dividends.

Almost every American will be hit. Most will feel the impact of a rise in payroll taxes and higher income tax rates, with middle-income Americans facing an average tax increase of almost $2,000. Those on low incomes will suffer the withdrawal of tax credits, while high earners will face punitive taxes on high-end healthcare plans and a squeeze on their investments.

You don’t have to agree with Barack Obama’s former adviser Christina Romer – who estimates that increasing taxes by 1 per cent of GDP will lead to a 3 per cent reduction in GDP overall – to see that tax rises of this magnitude are likely to be very damaging, especially in the context of an anaemic and largely jobless economic recovery. Some wealth managers are already advising investors to sell off equities to avoid being hit by capital gains tax increases.

But even avoiding these tax rises wouldn’t leave the US with a rational tax code. Policymakers desperately need to comprehensively reform the code, thereby eliminating a maze of exemptions, deductions, and special favours, while cutting rates across the board. Unfortunately, that’s not how Washington works.

When it comes to the spending cuts, the story is rather different. Here, at least, the threat to US economic health is vastly overstated. The lion’s share of the scheduled cuts come courtesy of the Budget Control Act of 2011, which mandates automatic cuts of around $109bn a year, starting on 2 January 2013 and continuing until 2021.

That sounds drastic, but it should be put in context. The federal government has run a trillion-dollar deficit four years in row, and currently borrows 30 cents of every dollar it spends. It barely raises enough revenue to cover “non-discretionary spending” on things like pensions, debt interest payments, and healthcare for the poor and elderly – let alone national defence (where America spends five times as much as its nearest competitor, China). Such profligacy may be manageable now, with treasury yields at record lows, but bond markets can be capricious. The US is storing up trouble for its future, even before you consider the impact of inexorably rising healthcare costs and an ageing population.

Moreover, these automatic cuts are calculated against a baseline of projected spending increases. As economist Veronique de Rugy has pointed out, “after the initial cuts, spending will grow by $1.65 trillion, as opposed to $1.8 trillion, between 2012 and 2021.” Defense spending – the target of half the automatic cuts – will initially fall to 2007 levels (in inflation adjusted terms) and then return to 2012 levels by 2018. So while these cuts will undoubtedly pose an administrative challenge, they are hardly the public sector apocalypse, or the open door to America’s enemies, that their critics would have you believe.

Indeed, the problem with the fiscal cliff spending cuts is not that they go too far, but that they don’t go nearly far enough. They entail no meaningful reforms to unaffordable and outdated entitlement programmes at home, and they impose no serious restraint on America’s trigger-happy interventionism overseas. They’re a start, but that’s all. In the long run, the US needs to do the same thing as every other Western state: radically re-think government from the ground-up and question absolutely everything.
Fiscal cliff or no fiscal cliff, the 112th US Congress has shown itself spectacularly ill-suited to that task. One can only hope its successor will do better.

Tom Clougherty is managing editor at Reason Foundation, a think tank based in Washington, D.C.