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Coffee House

Briefing: The US fiscal cliff

9 November 2012

3:49 PM

9 November 2012

3:49 PM

With the elections over and Barack Obama returned to the White House for four more years, the attention of US politicians has turned to the so-called ‘fiscal cliff’ — a collection of tax hikes and spending cuts that threaten to send the country back into recession. But what exactly is going on, and why?

The Bush tax cuts
George W Bush passed two major tax cut packages during the first term of his Presidency: the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. Together, they lowered federal tax rates on income (for example, the top rate fell from 39.6 to 35 per cent, and the bottom rate from 15 to 10 per cent), capital gains and dividends. They also increased child tax credits, tax breaks for married couples and raised the amount of deductions high-earners could claim.

But the Bush administration couldn’t get the 60 votes it needed in the Senate to pass the cuts in ordinary bills without them being filibustered. So to get them through, they made them ‘budget reconciliation’ bills, which can’t be filibustered (the same way Obama got his healthcare reforms through the Senate in 2010). But a reconciliation bill cannot add to the deficit for more than ten years, so the tax cuts were set to expire on 31 December 2010. Just before they did expire, though, Obama and the House Republicans agreed to extend them until 1 January 2013, as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

The 2001 act also raised the threshold for inheritance tax gradually before eliminating it entirely in 2010, though this was also due to expire in 2011, with inheritance tax returning to its pre-2001 set-up. The 2010 tax act instead retained inheritance tax for 2011 and 2012, but with a higher threshold of $5 million and a lower top rate of 35 per cent. These changes are set to be reversed for 2013, with the threshold falling to $1 million and the top rate rising to 55 per cent.

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The Obama tax cuts
Less than a month after taking office, President Obama signed the American Recovery and Reinvestment Act of 2009 — an $831 billion stimulus package of investment spending and tax cuts. The Act increased the child tax credit, the Earned Income Tax Credit for large families and the tax credits available to college students. These were originally due to have expired by now, but were extended to 1 January 2013 along with the Bush tax cuts by the 2010 tax act.

The 2010 act also cut the employee’s rate for Social Security from 6.2 per cent to 4.2 per cent for 2011. This was extended into 2012 but is set to return to 6.2 per cent for 2013.

The Alternative Minimum Tax
In 1982, Ronald Reagan signed the Tax Equity and Fiscal Responsibility Act which, among other things, established the Alternative Minimum Tax (AMT) — a rate intended to prevent high-earners from using deductions to reduce their tax liability too much (they either pay their normal income tax or the AMT, whichever is higher). But this impeded the effectiveness of the Bush tax cuts, as many high-earners found themselves paying the (un-lowered) AMT rather than the lower income tax rates. So Congress has repeatedly ‘patched’ the AMT by raising the amount people have to earn before it kicks in, but only for one or two years at a time. It last did so in 2010, for 2010 and 2011. If another patch isn’t passed, many high earners will face a much bigger tax bill for 2012 and 2013.

Spending cuts
In 2011, Obama and the Democrats reached a compromise deal with House Republicans in which the President and his party gave ground on deficit reduction in return for the Republicans raising the debt ceiling. The Budget Control Act of 2011 specified $917 billion worth of cuts and established the Joint Select Committee on Deficit Reduction, or ‘Supercommittee’, tasked with identifying a further $1.2 trillion of cuts. But it also said that if the Supercommittee failed, across-the-board ‘sequestration’ cuts of $984 trillion would be triggered, starting in 2013. This would include a $492 billion (9 per cent) cut in the defence budget, a $322 billion cut (7 per cent) in other discretionary spending and a $123 billion (2 per cent) cut to Medicare. The Supercommittee did fail, so those cuts are due to come in on 2 January 2013.

The economic impact
The Tax Policy Center estimates that, if America goes over the fiscal cliff, taxes would rise by an average of $3,500 a year per household — reducing after-tax income by 6.2 per cent. The Bipartisan Policy Center predicts that the sequestration cuts would cost more than one million jobs in 2013-14. The Congressional Budget Office projects that the combination would tip the US back into recession, with real GDP falling by 0.5 per cent and the unemployment rate rising to 9.1 per cent in 2013.

Deadlock in Washington
The main reason no solution has yet been found is that the government is divided: the Democrats control the White House and the Senate; the Republicans control the House of Representatives. There are actually some areas of consensus — for example that the Social Security cut should be allowed to expire, as it was only ever meant to be a temporary stimulus. But the Democrats want to retain the tax cuts for low- and middle-earners, but are determined not to extend the tax cuts for the rich, while the Republicans demand the opposite. And the Republicans want to protect the defence budget from spending cuts, whereas the Democrats don’t want other areas of spending cut too heavily. Tuesday’s elections did nothing to change the division, although the Democrats did increase their majority in the Senate and reduce the GOP’s majority in the House.

After his victory speech, Obama tried to phone the two highest-ranking Republicans — Speaker of the House John Boehner and Senate Minority Leader Mitch McConnell — to restart negotiations, only to be told they were asleep. Instead, Obama and Boehner spoke on Wednesday, after which the Speaker gave a speech declaring ‘Mr President, the Republican majority in the House of Representatives stands ready to work with you to do what’s best for our country.’ Perhaps recognising that the Democrats’ hand has been strengthened by their gains on Tuesday — and the fact that they won a majority of the national popular vote in both the Presidential and House elections — he struck a more conciliatory tone than previously. ‘For purposes of forging a bipartisan agreement that begins to solve the problem, we’re willing to accept new revenue, under the right conditions,’ he said, suggesting that the GOP might acquiesce to Democratic demands for tax increases. Obama will publicly set out his post-election position in a press conference this evening.

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