DRIVING OFF THE FISCAL CLIFF
The combination of expiration of tax cuts and automatic spending reductions at year’s end would mean throwing the country into a deep recession
Unless the laws are changed, at the end of this year a series of revenue enhancement measures coupled with mandated draconian cuts in spending would likely plunge the country into another deep recession, possibly even a depression. Included in the measures are the expiration of the Bush-era tax cuts, the payroll tax reduction, and certain tax-relief provisions. These revenue enhancements are meant to bring significant new funds into the federal coffers. In addition, on the spending side, a series of severe reductions known as “Sequestration” would automatically cut outlays across the board, with a particularly devastating impact on defense spending.
This is the so-called “Fiscal Cliff” the nation will drive over unless Congress and the President agree in the interim on a comprehensive deficit reduction package. And there is little chance of that happening!
Impact of the Revenue Enhancements and Spending Cuts
On the plus side, the revenue increases and spending cuts should significantly cut our annual deficits. The expiration of the Bush tax cuts is far and away the major factor on the revenue increases. Should these and lesser, more recent, tax reductions be allowed to phase out, that could bring as much as $400 billion into the U.S. Treasury. On the spending side, sequestration would reduce defense and entitlement spending roughly equally, with $27 billion each in 2013 for defense and non-defense spending, plus $12 billion in cuts to Medicare.
The deficit would be reduced by a net $560 billion in 2013, nearly half the $1.4 trillion deficit. Deficit reduction could be as high as $7.1 trillion over a decade, which advocates feel, would mean a reduction in the debt burden and higher growth rates over the long term.
On the negative side, the CBO estimates that the total impact of these provisions could mean a 4% reduction in the GDP growth rate next year. No doubt the nation would be thrown back into recession.
While the provisions ostensibly call for equal cuts to defense and entitlements, in fact because military spending accounts for a much smaller percentage of total federal outlays, the Pentagon would be hit much harder. Some estimates posit that sequestration would result in $1 trillion in cuts to defense spending over the next decade. It would likely result in the smallest Army since WWII, the smallest Air Force in the history of that service, and the smallest Navy since the First World War!
It should be noted that others feel that DOD would not be hurt as badly as its protagonists insist. They point out that we spend more today on the military than we did during the height of the Cold War (in real, inflation-adjusted terms) and that our defense budget is greater than that of all of our allies and likely adversaries taken together. They would prefer that the U.S. be more discriminating in the use of force and encourage other countries to assume greater responsibilities. But that is another discussion for another day!
If the negative ramifications of the fiscal cliff are so great, why even consider such draconian spending cuts and revenue enhancements?
The simple answer is, “the deficit” and the “national debt”. The United States produced budget surpluses in the “Clinton-Gingrich” years, but has been posting increasing deficits every year since. While those shortfalls were once manageable, the annual deficit has soared recently, due to the combination of the recession, stimulus spending and tax cuts. Last year the deficit grew to over $1.4 trillion! The cumulative debt has now surpassed $15.8 trillion and soon will equal 100% of our national GDP. That has not happened since World War II!
Interest paid on the national debt is only 5% of the federal outlays right now, due to previous smaller annual deficits and especially to historically low interest rates. But interest on the debt is expected to quadruple by 2020 to $840 billion annually, and even higher if interest rates rise. It will soon be the 4th biggest spending account, a situation that simply can’t continue.
Prospects for debt reduction over the long term are not promising, with health care cost inflation and an aging population the primary deficit drivers. For the short term the deficit is driven more by the unemployment and the tax reductions that have been implemented.
The conundrum is this—the annual deficits and accumulated debt are simply not sustainable, yet any spending reduction measures or revenue enhancements are likely to drive the economy into recession. Most deficit hawks agree, but feel that if we don’t bite this bullet now, the end result will be a fiscal crisis of vast proportions.
Can the Fiscal Cliff be Averted?
With the two parties unable to agree on revenue measures or spending cuts, agreements were set in place to trigger automatic provisions at the end of this year. Most players felt that such a fiscal cliff would not happen—that more reasonable representatives and the White House would agree on a less draconian set of tax measures and spending cuts.
Not only has that NOT happened, but there is little prospect of any agreement this year. Certainly no compromise will be reached before the November elections. After that we have a 7-week “lame duck” Congressional session that is equally unlikely to convene a “Budget Summit” with the President (who himself may be a lame duck!) that will produce the grand compromise needed to prevent the “Fiscal Cliff” from occurring.
Both parties and the White House have drawn firm lines in the sand. For House Republicans especially, and the GOP in general, the Bush tax cuts and associated measures cannot be allowed to expire, but must be extended. Democrats, including the President, would agree except that they insist that taxes should rise for “the wealthiest”, principally those making over $250,000 (their tax rate would go from 35% to 39%). They also want deeper cuts to Defense and Medicare.
Republicans also insist there must be a fairer reduction in spending between defense and entitlements, with many insisting that the Pentagon must be spared entirely from the deficit reduction measures. The Democrats, led by Senate Majority Leader Harry Reid, insist on the allocation agreed on and claim that defense would not be unfairly singled out. Most likely this is a “going in” position and one they would compromise on if the GOP gave some ground on taxes.
Will we go over the Fiscal Cliff on Jan 1, 2013?
Most likely no, but not because the Congress and the President will reach a grand compromise budget agreement by that time. Probably the Congress and the White House will agree on a stop-gap measure that essentially kicks the can down the road for 3-5 months. However, that truly will be an interim step—the need to finally agree on a comprehensive deficit reduction and revenue enhancement package is critical to the long term health of the U.S. economy, even if that means considerable pain and anguish in the short term.
–Tyrus W. Cobb