On January 1, a massive package of U.S. tax hikes and spending cuts threatens to push the country back into recession in 2013. Kevin Carmichael examines the origins of the latest round of political gridlock in Washington
Federal Reserve chairman Ben Bernanke J. Scott Applewhite
Former U.S. president George W. BushChristopher Morris
U.S. President Barack Obama Jason Reed
Speaker of the House John Boehner answers a question at a news conference on Capitol Hill in Washington, Nov. 9, 2012.Larry Downing
A crowd of shoppers browse at Target on the Thanksgiving Day holiday in Burbank, Calif., on Nov. 22, 2012.Jonathan "Alcorn
Prologue: The fiasco
In the summer of 2011, Washington lost its mind.
For decades, Congress routinely raised the legislative debt ceiling. The newly elected Tea Party rebels in the Republican controlled House of Representatives refused tradition. Their intransigence pushed the United States to the edge of default.
On Aug. 2, President Barack Obama signed the Budget Control Act, which raised the debt ceiling by about $900-billion (U.S.) and cut spending by the same amount. The legislation also created the Joint Select Committee on Deficit Reduction, a collection of six Democrats and six Republicans, to agree $1.5-trillion in further deficit reductions. If the committee failed, the administration would have to implement across-the-board cuts of $1.2-trillion over ten years.
Standard & Poor’s lost faith in the U.S. legislative process and dropped the country from its elite group of top-rated sovereigns. The “super committee” failed, triggering a first round of roughly $100-billion in arbitrary budget cuts in 2013.
Ben Bernanke: Wordsmith
At some point before congressional testimony early in 2012, Federal Reserve chairman Ben Bernanke looked into his crystal ball. This is what he saw:
“Under current law, on Jan. 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases,” Mr. Bernanke told the House Financial Services Committee in late February. “I hope that Congress will look at that and figure out ways to achieve the same long-run improvement without having it all happen at one date.”
Little discussed during the debt ceiling fiasco was the more than $500-billion in tax increases that were scheduled to take effect with the automatic spending cuts. Journalists and pundits were desperate for a pithy way to describe all that. “Fiscal cliff” was inelegant, but it served the purpose.
He haunts us still
They are known as the “Bush tax cuts.”
In his first year as president, George W. Bush proposed a massive tax reduction plan. Because the scheme disproportionately favoured richer Americans, Democratic legislators blocked permanent tax cuts. To get around their opposition, the White House and congressional Republicans set the tax cuts to expire in a decade.
Mr. Bush and his advisers knew it would be difficult for future leaders to allow his tax cuts to revert to previous levels. In 2010, Mr. Obama and Congress struck an agreement to extend them for two years as part of an economic stimulus measure.
The Tax Foundation, a conservative research group, puts the cumulative effect of ending the Bush tax cuts at some $170-billion, the biggest segment of the fiscal cliff.
All taxpayers would see their individual rates rise, and levies on dividends and capital gains would climb. Taxes on inheritance would jump to 55 per cent on estates worth more than $1-million from 35 per cent on transfers above $5.1-million.
The Obama tax cuts
As the recovery sputtered in 2010, President Barack Obama pushed for a mini-stimulus package, although no one associated with the White House called it that, so maligned was the president’s original fiscal rescue.
The president won congressional backing for a one-year cut of employees’ contribution to Social Security to 4.2 per cent of income from 6.2 per cent. The reduction was extended for a second year in 2011. The Tax Foundation values the payroll tax holiday at $125-billion a year.
Other stimulus-related measures are set to run their course. One of the clumsier features of the U.S. tax code is the Alternative Minimum Tax, which was created in 1969 to catch wealthy tax dodgers, but over time crept up on the middle class because it isn’t indexed to inflation. Congress tends to pass an “AMT patch,” and in 2010 set the threshold for paying the AMT at $48,450 for two years. In 2013, the AMT exemption is set to drop back to $33,750. Potential hit, according to the Tax Foundation: $88-billion.
The Obama stimulus plan also allowed businesses to temporarily deduct the full value of some machinery and equipment. That’s over. There also are a slew of temporary tax measures that are routinely extended, but haven’t yet been for 2013. The Tax Foundation says those measures are worth about $88-billion.
And last, but not least
If there was one important policy debate in the 2012 presidential election, it was over taxing the rich. President Barack Obama was for it, and his Republican challenger Mitt Romney was against raising anyone’s taxes.
But Mr. Obama already had raised taxes on the rich. His Affordable Care Act – “Obamacare” – includes something called the Medicare Payroll Tax, which will raise $85-billion over ten years by applying a surtax of 3.8 per cent on investment income earned by households making more than $250,000 a year. The tax takes effect in 2013.
Battle lines drawn
John Boehner, the Republican speaker of the House of Representatives, surprised many politicians by stating clearly on the day after the election that he was open to raising government revenue. But he wants this to be done by closing loopholes and ending tax breaks. Republicans want the Bush tax cuts to become permanent.
President Barack Obama likes the idea of closing loopholes and curbing tax breaks. But he says he’s skeptical that will raise enough money to meaningfully narrow a budget deficit that has exceeded $1-trillion for four consecutive years. The president says the election gave him a mandate to raise the tax rates on the wealthiest Americans. But he doesn’t say the top rate has to return to its previous level of 39.6 per cent from the current 35 per cent. And he says he’s open to Republican demands to overhaul Medicare and Medicaid and cutting discretionary spending.
You choose: Recession or a 'very good' 2013
With the U.S. economy growing at a lacklustre annual rate of about 2 per cent, the blow to demand represented by the fiscal cliff would cause a recession, according to the Congressional Budget Office, the International Monetary Fund, and the Federal Reserve.
Concern over future fiscal policy already is hurting the economy because businesses are too nervous to invest, Fed chairman Ben Bernanke said in New York on Nov. 20. That’s too bad, because otherwise, the prospects for the U.S. economy are looking up.
“Such uncertainties will only be increased by discord and delay,” Mr. Bernanke said. However, “co-operation and creativity to deliver fiscal clarity…could help make the new year a very good one for the American economy.”
Lawmakers must both dull the immediate blow from the cliff and show they are serious about constraining debt that has breached 70 per cent of gross domestic product. They have until the end of the year. The world is watching.