What the cliff means, and why America’s deficit woes are so intractable
Now, with less than three weeks to go, the pace has at last picked up. Mr Boehner and Mr Obama (pictured above) have talked twice in the past week, and representatives of both have exchanged offers. Publicly they say they are still far apart, but that is to be expected: serious negotiations seldom take place in front of cameras.
The absence of failure, at least so far, is seen by some as good news. That certainly goes for the stockmarket, which has recovered all its post-election losses. The outside world has long assumed that Mr Obama and Congress would strike a deal, because the alternative is too awful. Starting on January 2nd, taxes would jump for almost all taxpayers; a payroll-tax cut and enhanced unemployment benefits would expire; across-the-board cuts to federal spending would begin; and a clutch of other tax and spending measures would take effect. The total fiscal impact equals roughly 5% of GDP over a full year, easily enough to tip America’s economy back into recession.
To the rest of the world, the fiscal cliff seems like a freak of nature, the unintended consequence of America’s adversarial system of government. But that is too simplistic. The cliff is the product of two much deeper underlying strains. America faces an unprecedented structural gap between federal spending and federal revenue; and the political system is polarised over how that gap should be closed. Both problems have been a long time in the making, and neither is likely to go away even if a plunge over the edge is avoided.
Fiscal policy has consumed presidents since at least 1981, when Ronald Reagan slashed income-tax rates and boosted defence spending, ushering in years of deep deficits. Although the fights certainly got nasty, most important fiscal legislation in that decade was bipartisan. Large numbers in both parties voted for Mr Reagan’s original tax cuts and for the tax increases that followed; for the amendments to Social Security in 1983 that raised taxes and curbed benefits and extended the programme’s life; and for the 1986 tax-reform act that brought down personal and corporate rates and broadened the tax base by closing many loopholes. Democrats also provided support for George Bush senior’s tax increases and spending cuts in 1990.
That, however, was to be the last time Republicans agreed to higher taxes. In 1993 Bill Clinton’s deficit-reduction deal, raising taxes and cutting spending, passed with no Republican votes. Republicans did negotiate a balanced-budget pact with Mr Clinton in 1997, but only because plummeting deficits made it possible to cut capital-gains taxes along with spending.
The origins of today’s fiscal cliff lie a few years later, when George W. Bush cut tax rates on both regular income and capital gains and dividends. Democratic opposition forced Mr Bush to pass his tax cuts using a filibuster-proof Senate procedure that meant they had to expire at the end of 2010.
When Mr Obama came to office, his first big measure was a two-year stimulus plan that attracted no Republican House votes. At the end of 2010 the two sides agreed to a truce: Mr Obama extended all Mr Bush’s tax cuts to the end of 2012, and in return Republicans agreed to more stimulus, by cutting payroll taxes and extending unemployment benefits, also until the end of 2012. The next summer the two joined battle again as the Republicans threatened to let the Treasury run out of authority to borrow, risking default, without steep spending cuts. The compromise: $917 billion in spending cuts over the next decade, and $1.2 trillion more to begin, automatically, in January 2013 unless the two sides came up with a better alternative, which they failed to do.
The clustering of so much fiscal tightening at one moment in time was thus both deliberate and perhaps inevitable, given both the political divisions and the stakes. America’s deficits have exceeded $1 trillion for four years in a row. Though the deficit has fallen from 10% of GDP in 2009 to 7% in the fiscal year that ended on September 30th (see chart on next page), that is still higher than in any year since 1946. The figure should shrink in the years ahead as the economy recovers. But if there are no changes to the current path of taxes and spending, the Congressional Budget Office reckons it will start rising again in 2019, hitting an unaffordable 7% by 2023 as the mounting cost of health care and pensions begins to swamp the budget.
Eugene Steuerle, who served in Reagan’s Treasury Department and is now a scholar at the Urban Institute, a think-tank, says the current problem is far greater than previous ones because the structure of taxes and spending is so badly distorted that there is no way to fix it without widespread pain. This, in turn, feeds the divisions between the parties, since the necessary solution would require tax increases or spending cuts on a scale that one party, or both, will find repugnant.
Mr Obama originally asked for $1.6 trillion in higher revenues over the coming decade, though he is said to have dropped that to $1.4 trillion. Mr Boehner has formally offered $800 billion of higher revenue—a huge concession for a Republican—provided it comes through limiting deductions, exemptions and other loopholes (collectively called tax expenditures), rather than raising rates. Mr Obama has all but slammed the door on that approach. Gene Sperling, his chief economic adviser, says that it is impossible to raise anything like $1 trillion solely by closing loopholes for the rich once realistic exceptions, such as for charitable giving, are made. At most that approach yields only around $400 billion.
Mr Obama is open to tax reform, including for corporations, whose support he needs to get Republicans to negotiate. But not immediately. He would rather force Republicans to extend the middle-class tax cuts now and let rates rise on the rich as a down-payment on deficit reduction. That would provide a higher “baseline” level of revenue that could then be reapportioned in negotiations over tax reform in 2013.
Even as some Republicans hint at conceding on tax rates, they complain that Mr Obama has yet to do the same on spending. He has offered only $400 billion of cuts, which barely scratches the main problem: the growing cost of entitlements, principally Social Security (pensions) and Medicare and Medicaid, which provide health care for the elderly and poor, respectively. Mr Obama has proposed cutting Medicare fees to hospitals, nursing homes, drug manufacturers and other health-care providers. But Medicare’s own actuaries doubt such a strategy is sustainable over the long term, because providers will lose ever more money on Medicare patients and will eventually stop accepting them.
Republicans would like to see changes to eligibility or benefits, such as less generous inflation-indexing for Social Security, higher premiums for affluent Medicare beneficiaries, and a rise in the Medicare eligibility age from 65 to 67. Mr Obama has been open to all three in the past, but Democratic resistance seems to have stiffened. Raising the Medicare eligibility age “asks the most vulnerable citizens to pay more with little to show for it in terms of long-term deficit reduction”, says Nancy Pelosi, the Democratic leader in the House.
This doesn’t mean Democrats will refuse to include cuts to benefits in the deal. But “what Democrats are prepared to give will depend on the overall amount of revenue Republicans are willing to bake in”, according to a leading Democrat.
Republicans have little leverage of their own. If the Bush tax cuts expire, Democrats will presumably simply propose to restore them in January for those earning less than $250,000, daring Republicans to block them. A recent poll by the Pew Research Centre and the Washington Post found that 53% of voters would blame Republicans if the nation toppled off the fiscal cliff, while just 27% would blame Mr Obama. Some Republicans have suggested giving up the fight on tax rates, and instead insisting on entitlement cuts as the price of raising the debt ceiling, which the Treasury is expected to hit in February or March. But Democrats consider that an empty threat; if the Republicans don’t want to be blamed for a recession-inducing rise in tax rates, they certainly do not want to be held responsible for a panic over possible default.
These dynamics all work in favour of a deal, largely on Mr Obama’s terms. But there are two big risks. The first is that it will not be big enough. Negotiators have long thought a “grand bargain” would involve cutting spending and raising taxes by $4 trillion over the coming decade, relative to what they otherwise would be. The $4 trillion amounts to roughly 2% of GDP. But when all the future obligations of the federal government are counted, Alan Auerbach, an economist the University of California at Berkeley, reckons it would actually take higher taxes and reduced spending worth 8.4% of GDP to stabilise the debt at its current share of GDP. The reason is that America’s real fiscal problems relate not to the current deficit, which mostly derives from the weakness of the economy, but from the growth of entitlements over future decades. Republicans have been more serious about addressing that problem, but neither party has a credible proposal on the table.
Polarisation makes it harder to strike a deal, and harder to make any deal stick since the other side will try to undo it after the next election. Republican candidates for the presidential nomination of 2016 may well feel obliged to repudiate any tax increase that is agreed on now.
On the other hand, both Mr Obama and Mr Boehner know their legacies depend on finding a lasting solution to the deficit problem. If the current negotiations do succeed in turning America’s fiscal tide, history will conclude that the fiscal cliff made it possible. But don’t expect anyone to be grateful.
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