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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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Political Debt Dancing

A decision does not have to be reached by the end of 2012. The US Treasury can juggle its finances to purchase time till perhaps February 2013, especially if an agreement is likely. The major constraint is the need to increase the US government's borrowing cap or debt limit (currently US$16.4 trillion), which will be reached late in 2012 or early 2013.

Necessary reform of the tax system, especially a broadening of the tax base, and all spending, including social welfare programs, is unlikely to be politically easy.

The reelected President Obama's ability to implement policy is constrained by continued Republican control of the House of Representatives. The Republicans remain reluctant to entertain tax increases or reductions in exemptions. The Democrats remain reluctant to consider reductions in entitlements and spending.

President Obama asserts that he has a mandate to reform the budget, especially increase taxes on wealthier Americans. Having lost the presidential election and also having failed to make hoped-for gains in Congressional elections, the Republicans are defensive. The GOP position is complicated by its fractious internal politics. More conservative elements believe that the loss was due to a shift to centrist policies and a return to more strict conservatism is required.

Republican House Speaker John Boehner has appeared conciliatory, signaling a willingness to consider some higher taxes. In the fissiparous world of US politics, nothing is guaranteed, especially given the short electoral cycle. The prospects of a definitive grand bargain remain poor. The more likely scenario is an incremental strategy.

A short term compromise will be needed, entailing extensions of some tax cuts and delaying some spending cuts. Negotiations on deeper structural tax and spending reforms may take longer. The latter would focus on some tax increases and some adjustment to spending.

President Obama may get some higher taxes. Republicans might accept higher income taxes, particularly for those earning more than $1 million per annum (rather than US$250,000 currently proposed). Some tax deductions and reporting loopholes may also be eliminated. In return, the administration may agree to changes in entitlement, such as higher Medicare retirement age and changes to indexation of Social Security benefits for inflation. There would probably also be cuts in spending on defense and other social welfare programs such as Medicaid.

The fiscal cliff or the measures likely to be adopted may not to be enough to address the deep-seated problems of American public finances.

What is needed is a radical overhaul of the tax system, including probably a value added tax and wind back of complex deductions and subsidies. What is also needed is a review of all spending, including defense and social welfare, to better target expenditure and align it with tax revenues.

But even with this action, without strong economic growth and decreases in unemployment, it is difficult to see a significant improvement in American public finances. The recent CBO report concluded that "[very few policies] are large enough, by themselves, to accomplish a sizeable portion of the deficit reduction necessary."
No positions in stocks mentioned.

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