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December 24, 2012

SCHANSBERG: Facing the fiscal cliff

As the daily headlines attest, President Obama has some crucial business with this “lame-duck” session of Congress before he begins his second term. Because of temporary tax cuts, previous budget deals and procrastination in dealing with the debt, the country now faces a “fiscal cliff” on New Year’s Day.

The stakes are high. All working households are scheduled to pay more taxes. And a feeble labor market and a macro economy are bracing for the impact of much higher taxes and, perhaps, reduced government spending.

The key factors are the Budget Control Act of 2011 (BCA) and the scheduled end of a handful of tax cuts. The BCA lays out automatic budget cuts to be split between military and domestic spending: $55 billion in both categories. This would result in a 9 percent cut to the Pentagon and an 8 percent cut in domestic programs — but only when compared with their regularly scheduled increases.

The tax increases would be much larger: about $500 billion overall or what the Urban Institute’s Tax Policy Center estimates to be $3,500 per household on average and $2,000 for “middle-income” households.

About $156 billion of this is the expiration of the Bush-Obama income tax cuts — a big hit for the half of households who pay federal “income taxes.” Marginal tax rates would increase across the board — from 10 to 15 percent on the lowest end and 35 to 39.6 percent on the highest end. The child tax credit would be reduced from $1,000 to $500 per child and would no longer be refundable.

As for the famous tax cuts on those earning over $250,000, their expiration would raise about $23 billion. Higher tax rates for all capital gains and dividends would raise about $25 billion. The estate tax is currently 35 percent on wealth over $5.12 million and would revert to 55 percent on wealth over $1 million, raising about $10 billion from business owners, farmers and other wealthy people.

There are four other significant tax increases on the horizon. First, “accelerated depreciation” would end — a subsidy to business which artificially boosts the attractiveness of capital. Second, Congress will consider another Band-Aid for the “alternative minimum tax” (AMT) — an arbitrary limit on loopholes. If not, the AMT would expand from 5 million to 25 million households, raising their taxes by $3,700 on average. Third, ObamaCare will add new taxes of $23 billion, mostly from a payroll tax increase on high incomes. Fourth, Obama’s “payroll tax holiday” will expire, increasing taxes by $125 billion on all workers.

Of course, all of these are estimates. We know higher taxes will reduce economic activity, harming individuals and the macro economy. But we don’t know how much the economy will be harmed by — or how strongly people will respond to — higher taxes.

The White House’s 2013 projected revenues assume an 18 percent increase in individual income taxes and a 41 percent increase in corporate taxes. I’m not sure how much of the predicted increase assumptions about higher tax rates — and how much is optimism about economic recovery. But it’s difficult to be optimistic about the economy when it’s lukewarm and about to be saddled with big tax increases.

The problem is that we have massive deficits and rapidly growing debt. The nonpartisan Congressional Budget Office says that we need “fundamental” reform. The White House estimates that revenues will only cover interest on the debt and “entitlement” spending in 2012. All other functions of government are being financed through borrowing.

Continuing this will lead to bankruptcy. We’re speeding toward a “debt cliff,” but fixing the problem will be painful. To reduce deficits, we need reduced spending or higher tax revenues (not necessarily the same as higher tax rates). We know that much higher taxes cannot work, since economic activity will stagnate or disappear as rates increase. Beyond that, your policy preferences will depend on your confidence in government’s ability to spend money better than the private sector — and your ability to imagine more subtle costs of tax increases, compared with more obvious costs of spending reductions.

There are three issues at hand. First, the underlying problems are our massive federal budget deficits and rapidly growing budget debt. Second, the potential solutions are also problematic. Actual reductions in government spending (however unlikely) and big increases in tax rates (and likely, an increase in tax revenues) would make it even more difficult for the economy to grow.

Third, all of this contributes to what economists call “regime uncertainty.” Nobody knows what Congress and President Obama will do — from the extent to which they’ll address the problem to the particular solutions they’ll embrace. And nobody knows if we’re near the cliff that limits the size of the debt. The debt may soon be perceived by investors as unmanageable. If so, they will refuse to loan money to the government — or will require a higher interest rate. This means higher debt payments, more trouble for our economy and tighter austerity measures in the future. Finally, no one understands how ObamaCare will be implemented — or how that will impact business decisions.

Any investment becomes more difficult when risk and uncertainty increase. Consumers are less likely to buy cars and homes. Businesses are less likely to hire workers and expand their scale of operations. Investors will require a higher rate-of-return to offset the higher risk — in order to make their capital available. And all of the above will reduce economic growth.

Politicians are fond of “cliffs” these days. You can understand why, right? Because the general public doesn’t pay much attention to political economy, politicians have a strong incentive to ignore subtle costs and to procrastinate by pushing costs into the future. If they’re going to postpone tough decisions and add a lot of uncertainty to the economy, perhaps we should send them over an electoral cliff at our next opportunity.

— D. Eric Schansberg, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation, is a professor of economics at Indiana University Southeast.

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