The world is focussed on the fiscal cliff, a term referring to the scheduled reductions in the US budget deficit, by way of expiring tax cuts and mandatory spending cuts. The fiscal cliff may ironically improve public finances, reducing the deficit and slowing the increase in debt levels—America’s debt mountain. But the fiscal cliff will not of itself solve America’s fundamental financial problems.
US government debt currently totals around $16 trillion. The US Treasury estimates that this debt will rise, in absence of corrective action, to around $20 trillion by 2015, over 100 percent of America’s Gross Domestic Product (GDP).
There are also additional current and contingent commitments not explicitly included in the debt figures, such as US government support for Freddie Mac and Fannie Mae of over $5 trillion and unfunded obligations of over $65 trillion for programmes such as Medicare, Medicaid and Social Security. US state governments and municipalities have additional debt of around $3 trillion.
Despite growing concern about the sustainability of its debt levels, demand for US Treasury securities from investors and other governments remains strong.
‘Innovative’ monetary policy from the US Federal Reserve has allowed the government to increase its debt levels. Around 60-70 percent of US government bonds have been purchased by the Federal Reserve, as part of successive rounds of quantitative Easing (QE).
Federal Reserve action has been a key factor in keeping rates low, allowing the US to keep its interest bill manageable despite increases in debt levels.
But the current position is not sustainable.
In January 2013, in the absence of political agreement, a series of automatic tax increases and spending cuts will be triggered. These were part of the 2011 legislative package which increased the debt ceiling allowing the government to continue to borrow.
Several temporary tax cuts will expire. The total amount involved is around $500 billion through to September next year. Automatic spending cuts will also commence, totalling about $600 billion per year and $6.1 trillion over 10 years.
The automatic tax increases, non-renewal of tax cuts and spending cuts are equivalent to about 5 percent of GDP. In a recent report, the non-partisan Congressional Budget Office (CBO) estimated that the tax increases and spending cuts would reduce output by approximately 3 percent and increase unemployment to 9.1 percent by the end of 2012.
Bringing US public finances under control requires bringing budget deficits down, through spending cuts, tax increases or a mixture. The fiscal cliff is merely a step down that long road.
Government revenues would need to increase by 20-30 percent or spending cut by a similar amount.
The US has a lower tax-to-GDP ratio (around 18 percent) than even much maligned Greece (around 20 percent). The tax-to-GDP in most developed countries is closer to 30 percent.
Given 45 percent of households do not pay tax (because they don’t earn enough or through credits and deductions) and 3 percent of taxpayers contribute around 52 percent of total tax revenues, a major overhaul of the taxation system would be necessary. Tax reform, especially higher or new taxes, is politically difficult.
Large components of spending—defence, homeland security, social security, Medicare, Medicaid, (growing) interest payments—are difficult to control and also politically sensitive, making it difficult to reduce.
Reducing the budget deficit and debt may also mire the US economy in a prolonged recession. The economy may fall into a deep recession, increasing the budget deficit and driving government debt to higher levels. This is precisely the experience of heavily indebted peripheral European nations, such as Greece, Ireland, Portugal, Spain and Italy.
Political Debt Dancing
The re-elected President Obama’s ability to implement policy is constrained by continued Republican control of the House of Representatives. The Republicans remain reluctant to entertain tax increases or reductions in exemptions. The Democrats remain reluctant to consider reductions in entitlements and spending.
President Obama asserts that he has a mandate to reform the budget, especially increase taxes on wealthier Americans. Having lost the presidential election and also having failed to make hoped for gains in Congressional elections, the Republicans are defensive. Their position is complicated by fractious internal politics. More conservative elements believe that the loss was due to a shift to centrist policies and a return to more strict conservatism is required.
Republican House Speaker John Boehner has appeared conciliatory, signalling a willingness to consider some higher taxes. In the fissiparous world of US politics, nothing is guaranteed, especially given the short electoral cycle. The prospects of a definitive grand bargain remain poor. The more likely scenario is an incremental strategy.
A short-term compromise will be needed, entailing extensions of some tax cuts and delaying some spending cuts. Negotiations on deeper structural tax and spending reforms may take longer. The latter would focus on some tax increases and some adjustment to spending.
President Obama may get some higher taxes. Republicans might accept higher income taxes, particularly for those earning more than $1 million per annum (rather than $250,000 currently proposed). Some tax deductions and reporting loopholes may also be eliminated. In return, the administration may agree to changes in entitlement, such as higher Medicare retirement age and changes to indexation of social security benefits for inflation. There would probably also be cuts in spending on defence and other social welfare programmes.
Such measures may not be enough. What is needed is a radical overhaul of the tax system, including probably a value added tax and wind back of complex deductions and subsidies. What is also needed is a review of all spending, including defence and social welfare, to better target expenditure and align it with tax revenues.
But even with this action, without strong economic growth and decreases in unemployment, it is difficult to see a significant improvement in American public finances. The recent CBO report concluded that “[very few policies] are large enough, by themselves, to accomplish a sizeable portion of the deficit reduction necessary”.
Our Debt, Your Problem