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Satyajit Das: America's Fiscal Cliffs and Debt Mountains

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It is unlikely that America's problems will stay in America. The rest of the global economy is tied to the US as it edges closer to the cliff.

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Cliff-Hanging

In January 2013, in the absence of political agreement, a series of automatic tax increases and spending cuts will be triggered. These were part of the 2011 legislative package which increased the debt ceiling allowing the government to continue to borrow.

Several temporary tax cuts will expire. The total amount involved is around US$500 billion through to September next year.

These include President George Bush's tax cuts on income, investments, married couples, families with children, and inheritances, which were extended for two years by President Barack Obama. In addition, the Alternative Minimum Tax (AMT) would commence, affecting up to 26-30 million middle-class Americans, increasing their tax bill by an average of US$3,700. The payroll-tax cut of 2% and extended unemployment benefits for the long term unemployed (both implemented by the Obama Administration to stimulate the economy) would also expire. A number of other smaller tax cuts for individuals and business (most notable tax credits for research and development and a deduction for state sales taxes) would also terminate.

Automatic spending cuts will also commence, totaling about US$600 billion per year and US$6.1 trillion over 10 years. The spending cuts would cover most government programs including cuts in defense spending and domestic programs. Medicare, the federal health program for the elderly, would reduce payments including a sharp reduction (as much as 30%) in reimbursements to doctors.

The automatic tax increases, non-renewal of tax cuts, and spending cuts are equivalent to about 5% of GDP. In a recent report, the non-partisan Congressional Budget Office (CBO) estimated that the tax increases and spending cuts would reduce output by approximately 3% and increase unemployment to 9.1% by the end of 2012.

Corrective Services

Bringing US public finances under control requires bringing budget deficits down, through spending cuts, tax increases or a mixture. The fiscal cliff is merely a step down that long road.

The task is Herculean. Government revenues would need to increase by 20-30% or spending cut by a similar amount.

The US has a lower tax-to-GDP ratio (around 18%) than even much maligned Greece (around 20%). The tax-to-GDP in most developed countries is closer to 30%.

Given 45% of households do not pay taxes (because they don't earn enough, or through credits and deductions) and 3% of taxpayers contribute around 52% of total tax revenues, a major overhaul of the taxation system would be necessary. Tax reform, especially higher or new taxes, is politically difficult.

Large components of spending -- defense, homeland security, Social Security, Medicare, Medicaid, (growing) interest payments -- are difficult to control and also politically sensitive, making it difficult to reduce.

Reducing the budget deficit and debt may also mire the US economy in a prolonged recession.

In 2009, students at National Defense University in Washington, DC, "war gamed" possible scenarios for bringing the US debt under control. Using a model of the economy, participants tried to get the federal debt down by increasing taxes and reducing spending.

The economy promptly fell into a deep recession, increasing the budget deficit and driving government debt to higher levels. This is precisely the experience of heavily indebted peripheral European nations, such as Greece, Ireland, Portugal, Spain and Italy.

As one participant in the National Defense University economic war game observed about the process of bringing US public finances under control: "You'll never get reelected and you may do more harm than good."
No positions in stocks mentioned.

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