Obama 2.0, the fiscal cliff and another recession?

Last month, after the costliest and arguably, the nastiest campaign in history, Barack Obama secured four more years in the most high-profile job in the world. Voters picked Obama over millionaire Romney despite a stubbornly high unemployment rate and a weak economic recovery in the aftermath of the Lehman collapse in 2008.

The fragile economy was the decisive factor in the 2012 Presidential race. People accepted Obama’s handling of the economy and decided to stand with him. However, a major challenge for the victorious President and also the houses of Congress is the looming fiscal cliff that threatens to deal a heavy blow to the American economy and crush any possibility of recovery when if it kicks in next year. With barely three weeks remaining for the crisis to peak, frantic negotiations are on to avert it while economists calculate doomsday scenarios.

Fiscal cliff: What is it?

The fiscal cliff refers to the impact of around $500 billion in expiring tax cuts and automatic spending reductions set for 2013 as a result of successive failures by Congress to agree on some orderly alternative method of reducing budget deficits. A series of specific laws which are presently keeping the taxes low will be invalid. Simultaneously, a massive reduction of spending will also kick in from January 1. The origin of this reduction lies in the Budget Control Act of 2011. The Act was passed to prevent the country from falling defaulting on its debts; however, it was done so under an environment of a partisan stalemate with Republicans and Democrats disagreeing considerably on ways to reduce the budget deficit. The Act ultimately provided for a Joint Select Committee on Deficit Reduction to produce legislation by late November 2011 that would decrease the deficit by $1.2 trillion over ten years. If the committee failed to do so, as it in fact did, another part of the Act mandated automatic across-the-board cuts (known as "sequestrations"), split evenly between defense and domestic spending, beginning January 2, 2013.

Image: the reformed Broker

Other laws whose expiry can contribute significantly to the fiscal cliff include:

  • Reversion of the Alternative Minimum Tax thresholds to their 2000 tax year levels.
  • Expiration of measures delaying the Medicare Sustainable Growth Rate from going into effect, most recently extended by the Middle Class Tax Relief and Job Creation Act of 2012 (MCTRJCA).
  • Expiration of the 2% Social Security payroll tax cut, most recently extended by MCTRJCA.
  • Expiration of federal unemployment benefits, most recently extended by MCTRJCA.
  • New taxes imposed by the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010.

Trickle-Down Economics and Bush Era Tax cuts

To go to the root of this crisis, one must understand the centrality of ‘Trickle-down economics’ to the economic policy of the United States and especially, the Republican party of the past twenty years. The idea that economic benefits including tax breaks for the wealthier sections such as big business will sooner or later benefit all sections of the society by ‘trickling down’ is the inspiration behind proposals such as the Bush Era tax cuts.

The idea that economic benefits including tax breaks for the wealthier sections such as big business will sooner or later benefit all sections of the society by ‘trickling down’ is the inspiration behind proposals such as the Bush Era tax cuts.

When President Bush took office in 2001, he had inherited a $230 billion budget surplus.The highest earners in the country were taxed at 39.6 percent of their normal earned income, 38.6 percent on dividend income and 20 percent on long-term capital gains like investments. With ample money in the coffers, Congress proposed widespread tax relief. The 2001 tax law called for rate cuts in every tax bracket and the creation of a new 10 percent tax bracket for the lowest earning households, those making zero to $12,000 in taxable income. Beforehand, the lowest rate had been 15 percent. As Congress drafted the law, the Congressional Budget Office was predicting $5.6 trillion budget surplus over the next ten years.

The subsequent 2001 EGTR Act and the 2003 JGTRR Act significantly lowered the marginal tax rates for nearly all U.S. taxpayers. The Bush tax cuts were to expire at the end of 2010. That year saw frenzied debate and intense bickering over whether to renew the lowered rates. The final solution was a two-year extension that was part of a larger tax and economic package, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. Before the tax cuts, the highest marginal income tax rate was 39.6 percent. After the cuts, the highest rate was 35 percent. The price of the extension has however been steep. In August 2010, the Congressional Budget Office estimated that extending the tax cuts for the 2011-2020 time period would add $3.3 trillion to the national debt, comprising $2.65 trillion in foregone tax revenue plus another $0.66 trillion for interest and debt service costs

U.S economy from 2007 to 2012: The Obama way

Both the debate in 2010 and the current one sharply bring into focus a key difference in ideology between the Republicans and Democrats. The Democratic road-map under Obama and Congressional Democrats, in the aftermath of his historic 2008 ‘hope-and-change’ victory, involved the injection of massive amounts of stimulus into the economy. The U.S Treasury bailed out auto majors GM, AIG, and many more with the $700-billion TARP (Troubled Asset Repurchase Programme). The Obama administration also made an attempt along with certain section in Congress to control Wall Street biggies with Dodd-Frank reform. The Federal Reserve cut short term rates to an effective rate of zero. That rendered the central bank unable to use further rate cuts to spur growth. Then they deployed Quantitative Easing (QE) and Operation twist to pump money into U.S economy. While Obama has been very keen on reducing the fiscal deficit, he has also made it clear that increasing government revenue is a key plank on his agenda. He thus seeks some 1.6 trillion in increased tax revenues to reduce deficits by increasing tax rates.

While Obama has been very keen on reducing the fiscal deficit, he has also made it clear that increasing government revenue is a key plank on his agenda.

It is this agenda that the Republicans have vowed to oppose tooth and nail. Citing Arthur Laffer’s Dynamic Scoring theory, which postulates that raising tax beyond a certain point would be counterproductive and lead to lesser revenue, they have argued that the recent elections have given no mandate to raise taxes.

Incidentally, both Republicans and Democrats want to keep low income tax rates in place for middle-income and low-income households. Democrats however insist that the wealthiest 2 percent should revert to the higher rates that were in place in the 1990s. President Obama has demanded that Republicans agree to raise taxes on the wealthy before any deal to avoid the fiscal cliff is struck. Supporting Obama's view point, a recent study by the Congressional Research Service adds that, there's no evidence that tax cuts spur growth.

What is likely to happen?

If the two sides do not agree on a deal by the end of the year, tax rates on income and investments will rise for all Americans, and government programs from the military to education will face deep, across-the-board cuts. Business tax breaks for everything from wind power to research costs would expire as well. Black Rock projected that U.S growth would be cut at least by half. It may lead to another recession in 2013 first quarter and unemployment rate of 9.2% beyond 2013. Besides, the tax cuts on businesses could affect the jobs of many in an environment where unemployment remains as high as eight percentage.

With Europe too in the throes of an economic crisis and the growth projections of countries like India showing a downward trend, a recession in the U.S. could have a negative impact on any chances of economic recovery worldwide. IMF too has warned that the going over the fiscal cliff would have large international spillovers. All eyes are definitely on Washington as the clock ticks on steadily.