US Fiscal Cliff Explained

One of the most talked about issues in US politics is the US fiscal cliff.

The fiscal cliff refers to the situation at the end of 2012, where a series of tax increases and spending cuts (worth $600bn)  are due to come into force automatically. This amounts to  This will reduce the budget deficit, but cause lower growth. The alternative is to reject these planned budget cuts and allow the deficit to continue to grow. This will allow stronger economic growth, but leave the debt issue unchallenged.

A complicating factor for US politics is the debt ceiling. This is the legal amount by how much the government can borrow. The debt ceiling can be raised, but it has to go through the Senate to be voted on. This gives scope for political wrangling and efforts to push for some favoured spending cuts in return for allowing debt ceiling to be raised.

The debt ceiling was raised on January 30, 2012, to a new high of $16.394 trillion.

The Budget Control Act of 2011 stated that at the end of 2012, if agreement hadn’t been reached on the way to reduce the deficit, there would be an automatic increase in taxes and spending cuts. This includes

  • End of last year’s temporary payroll tax cuts (resulting in a 2% tax increase for workers),
  • The end of certain tax breaks for businesses,
  • shifts in the alternative minimum tax that would take a larger bite,
  • the end of the tax cuts from 2001-2003,
  • taxes related to President Obama’s health care law.
  • Over 1,000 government programs – including the defense budget and Medicare are in line for “deep, automatic cuts.

If these policies are enacted at the end of 2012, there would be a substantial reduction in the budget deficit over the next few years. The budget deficit would fall from 8.5% of GDP in 2011 to 1.2% by 2021.

However, implementing these deflationary fiscal policy would seriously impact on the rate of economic growth. Higher taxes and deep spending cuts, would push the US economy back into a double dip recession. The CBO forecast that if the budget cuts come into effect, there will be negative growth of -0.5% in 2013. Without the budget cuts, there will be growth of 1.7% and unemployment much lower.

 

Economic Stat CBO
Baseline
Alternative
Scenario
Federal deficit in FY2013 $641 billion $1037 billion
Economic growth in FY2013 -0.5% of GDP 1.7% of GDP
Unemployment rate-  Oct Dec 2013 9.1% 8.0%
Public debt in 2022 58% of GDP 90% of GDP

 Alternative Scenarios

  • Allow tax increases and spending cuts to come into force
  • Ignore budget changes and continue with existing policies
  • Look for some compromise with moderate tax increases and spending cuts.

Tomorrow, I will look at how the US would be advised to look at the mistakes of the UK and Europe and avoid any unnecessary budget cuts which strangle economic recovery.

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3 Responses to US Fiscal Cliff Explained

  1. hortoris January 1, 2013 at 6:58 pm #

    Shouldn’t the west embrace a fiscal cliff, cut expenditure and public debt and learn to live a sounder economic existence

    • Tejvan Pettinger January 2, 2013 at 9:37 am #

      Greece, Spain and Portugal embraced a fiscal cliff, and it’s been a disaster for them. Mass unemployment, deep recession and a failure to reduce debt to GDP.

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