Obama and the fiscal cliff

Proving that true honeymoons are for first timers only, President Barack Obama returned the morning after the night before to his office/home at the White House and was immediately confronted with some of the immediate challenges he would face the second time round. There is no bigger a challenge than what is referred to as the ‘fiscal cliff,’ a combination of tax increases and spending cuts which are scheduled to go into effect January 2013 and thereby result in a corresponding reduction in the budget deficit.

In an address three days after the elections, President Obama claimed, with considerable justification, that he and his opponent Mr Mitt Romney had proposed to the electorate two competing visions for the reduction of the ballooning fiscal deficit and the national debt. Obama’s “vision” explicitly included the requirement that those whose income exceeded US$250,000 per annum contribute a bit more in the form of higher taxes. Mr Romney on the other hand had campaigned for a 20% across-the-board reduction in tax rates financed in part by the removal of tax-shelters such as charitable donations and mortgage interest deductions.

The new opposition
With the political system and culture of the US being what they are, Mr Romney is now part of the political history of that country. With no elected national, state or party office, Mr Romney’s brief role as leader of the Republicans now falls on John Boehner, the Speaker of the House of Representatives. Mr Boehner too claims a popular mandate for his party which retained control of the House, helped by what is euphemistically called re-districting led by his party and/or the courts. Speaking one week before a scheduled meeting with President Obama this coming Friday, Mr Boehner said that any deal to avert the fiscal cliff should include lower tax rates, the elimination of special interest loopholes and the revision of the tax code.

Both Obama and Boehner could soon learn of the catastrophic consequences of fighting at the edge of a cliff–higher taxes, a rise in the rate of unemployment and the country falling back into recession. One would think therefore that all this pre-meeting talk is no more than bravura and that both sides – already buffeted by their respective media friends to hold out – will see the need for some compromise. In my view Obama has a much stronger mandate and need not demonstrate the excessive caution with which the cloud of re-election overshadows the acts of first-term presidents.

Bush 2
The debate really goes back to the Bush 2 era when tax rates were reduced, when the economy was in surplus and when there was no war. The reasoning of President George Bush was that there could be no better time for the reinforcement of the supply-side doctrine pronounced by the patron saint of the Republican Party, President Ronald Reagan. But soon came 9/11 and two costly wars in Iraq, since ended by Obama, and Afghanistan which Obama is committed to end in 2014.

President Obama came into office in 2008 with a pledge to reduce the deficit and the national debt. In fact, just the opposite has taken place with the national debt increasing by more than $5 trillion during his first presidency. Mr Obama sought to explain – and the electorate appears to have accepted – that the increase was largely due to the wars and the policies of his predecessor. Duly excused if not forgiven, Mr Obama must now keep good on his promise not for his legacy but for the stability of his country and the world’s economy.

The price of failure
Meanwhile, Boehner is playing the kick-the-can-down-the-road game and has suggested that no real decision be taken for another year while the Congress and the Senate work on tax reform. Obama, emboldened by both the presidential as well as the popular vote last Tuesday seems ready to take on the Republicans in what might seem to be a test of wills and of principle. It is hard to understand why and how the Republicans, still to recover from a presidential loss that has left them shell-shocked, would be willing to take the country over the cliff for the cause of tax increases on the top 1% of the population. Hopefully, Boehner, who demonstrated a spirit of compromise in discussions with Obama in his first term, will be able to take that further on this occasion. While there are some who attribute blame to Obama for the failure of those discussions, Mr Boehner now has to win over the leadership of his own party in which failed VP candidate Paul Ryan, a supply-sider has a strong influence, if not being the principal contender.

So what in fact will happen if there is no agreement between Obama and Boehner? First the tax side. In addition to some tax cuts which have already expired but which are up for renewal in 2013, there are many specific changes which will automatically take place, some of which are too detailed for this column. In essence, however, the Bush-era tax cuts are set to expire, which will bring the tax system back to 2001 levels; President Obama’s 2 per cent payroll tax cut holiday will expire, and a series of other temporary tax cuts for businesses that Obama enacted will end.

Some groups in the US estimate that more than three out of four Americans will see some form of tax increase next year with the Bush tax cuts alone affecting 100 million persons. The Tax Policy Center estimates that the average US household would face an average of a $3,500 rise in their annual tax bill.

No hyperbole
This does not appear hyperbolic since some of the taxes cut across the board and will affect lower and middle-income groups. These are the very people whose cause Obama has championed since his days as a community organiser and who voted him a second term. The loss of the Earned Income Tax Credit, a refundable credit and the “payroll tax holiday,” a 2 per cent Social Security tax cut on the first $110,000 in wages together with the expiration of the Bush tax cuts, as well as tax and college credits will have real effects. It would be an unpleasant pill for Obama to swallow in the face of the hard line taken by his political opponents.

At the higher end, taxpayers will be hit with the Bush era tax rate changes. The two top tax brackets are set to rise from 33 and 35 per cent to 36 and 39.6 per cent respectively. Additionally, the capital gains and dividend tax rates will rise from 15 per cent while the 15 per cent dividend tax rate will equal income tax rates.

As I said above, some columnists, including Paul Krugman, a Nobel Laureate and New York Times columnist are advising Mr Obama to hang tough, that this is not the time to negotiate a “grand bargain” on the budget that snatches defeat from the jaws of his hard fought victory. His advice that Mr Obama should let the Republicans take the responsibility for driving the car over the cliff has risks, including the impact on the poor and the middle class, but Obama would no doubt recall that when Speaker Newt Gingrich did something not dissimilar on spending during the Bill Clinton presidency, the cost to the Republicans was considerable.

Mr Krugman argues that a stalemate would hurt Republican backers, corporate donors in particular, every bit as much as it hurt the rest of the country. As the risk of severe economic damage grew, Republicans would face intense pressure to cut a deal after all.

He takes a slightly less catastrophic view of the consequences of the cliff, pointing out that it is not like the debt-ceiling confrontation where terrible things might well have happened right away if the deadline had been missed. He argued that this time, nothing very bad will happen to the economy if agreement is not reached until a few weeks or even a few months into 2013.

And what about  the cuts?
Following the failure of the debt ceiling debacle, the US House of Representatives appointed a Joint Committee on Deficit Reduction under the authority of the Budget Control Act of 2011 with the mandate to find a way to cut spending by $1.2 trillion over the next ten years. Unlike so many other committees which are often set up to fail, this super-committee had no such option: if it could not come to an agreement, there would be a trigger – an automatic $1.2 trillion in spending cuts would occur, half from domestic spending and the other half from the Department of Defence. The automatic spending cuts will see the first $110 billion in cuts starting January 2, 2013.

This means that the Defense Department will see per cent across-the-board cuts, while “discretionary” programmes or those that do not have earmarked funds will face cuts of about around 8%. Certain to face cuts is the government-run health care programme for seniors which would face a 2 per cent cut in Medicare payments to providers and insurance plans.

Even as a visitor to the US myself, I find it hard to say how these cuts will affect even an area with which I am familiar, given the way the individual states and the federal government operate. But it is a fair bet that across the country, infrastructure, schools, public health and homeland security would be victims of the cuts.

There are some programmes that are exempt from the cuts. Specifically identified are Social Security, Medicaid, supplemental security income, refundable tax credits, the children’s health insurance programme, the food stamp programme and veterans’ benefits, while the White House has also said military personnel would be exempt from the cuts.

Some months ago the US Congressional Budget Office (CBO) projected that falling over the fiscal cliff could lead the US economy into a “significant recession.“ It estimated that the economy would shrink by 2.9 per cent in the first half of 2013 and by 0.5 per cent for the whole year and that the unemployment rate would increase to 9.1 per cent. It is now 7.9%.

There are those who argue that this is a lame-duck presidency – the period between two elected officials – and that nothing should be done now. Obama is unlikely to agree. Whether he will act like his predecessor George Bush did, boasting that he had won political capital which he was prepared to spend, remains to be seen.

Next Friday’s discussion between President Obama and Speaker Boehner should be a good pointer.

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