All the Hue and Cry about US Fiscal Cliff

Overview

Well the US elections are over and despite a resounding victory for Democrats and re-election of Obama for a second term, markets didn’t show much enthusiasm mainly due to a looming fiscal cliff which can derail the economy atleast in short term. So what is this fiscal cliff and what are the reasons and consequences of this cliff?

Fiscal cliff is a newly coined term which came from Federal Reserve Chairman Ben Bernanke, who used it to describe the adverse effect that will occur if automatic tax increases and massive spending cuts are allowed to take place in United States of America beginning in 2013. The laws which will result in fiscal cliff is will include tax increases due to the expiration of the Bush tax cuts and spending cuts under the Budget Control Act of 2011.

Perils of Fiscal Cliff

According to an estimate by Congressional Budget Office in USA, while lower deficits and debt would definitely improve long-term economic growth, there will an increased risk of recession during 2013 if the deficit is reduced suddenly. As per the estimates, fiscal cliff if unattended to, will reduce fiscal deficit by almost half and over the next ten years, the United States public debt will be lowered by almost $7.1 trillion which is about 70% of the expected cumulative deficit over those ten years. The year-over-year changes for fiscal year 2012–2013 will comprise of a massive 19.63% increase in tax revenue and a 0.25% reduction in spending. Certain programs such as Social Security, Medicaid, federal pay (including military pay) & pensions, and veterans' benefits, are exempted from the spending cuts.

Laws Leading to Fiscal Cliff

• Expiration of the Bush tax cuts
• Across-the-board spending cuts to a number of programs as directed by the Budget Control Act of 2011;
• Alternative Minimum Tax reversion to their 2000 tax year levels
• Expiration of measures delaying the Medicare Sustainable Growth Rate from going into effect (the "doc fix")
• Expiration of the 2% Social Security payroll tax cut
• Expiration of federal unemployment benefits
• New taxes imposed by the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010.

Without any compromise in Congress, these provisions will automatically go into effect on Jan 1 or 2 2013 which may push US economy in recession. The total deficit reduction or debt avoidance in case we go into fiscal cliff without any compromise over ten years could be as high as $7.1 trillion, as against the $10–11 trillion debt increases if current policies are extended.

Road Ahead

While it’s imperative for US to reduce its public debt which stands at 69% of GDP as on 2011, it’s equally important to avoid the fiscal cliff as repercussions could be huge on not just the US economy but world economy as a whole. While Democrats under the leadership of Obama favors extending tax cuts to most tax payers barring the creamy layer, Republicans want tax break to be extended in its entirety. As things stand, while Senate voted in favor of President, U.S. House of Representatives rejected the President's tax proposal in 2012. The situation couldn’t get tricky and this could well be biggest test for Obama as the nation stands on a cusp of an important economic event which will shape up the global growth dynamics in times to come.

By Rajat Gupta – Research Analyst – Concept Securities Private Limited