What is the Fiscal Cliff and How Should it be Fixed?

The following is an excellent article from the Council of Foreign Relations (CFR) concerning the fiscal cliff.  In addition to describing the fiscal cliff, it explains the political issues behind how "we got here", the national impacts, the international impacts, and an historical perspective.  

The article is in italics.  From CFR:

The "fiscal cliff" is a term used in discussions of the U.S. fiscal situation to describe a bundle of momentous tax increases and spending cuts that are due to take effect at the end of 2012 and early 2013. In total, the measures are set to automatically slash the federal budget deficit by $607 billion or approximately 4 percent of GDP between FY 2012 and FY 2013, according to the Congressional Budget Office.  The abrupt onset of such significant budget austerity in the midst of a still fragile economic recovery has led most economists to warn of a double-dip recession in 2013 if Washington fails to intervene in a timely fashion.

But many analysts see little chance of a compromise before the November election, and questions remain on what action would be taken either in the lame duck session of Congress or in the early days of 2013. While taking no action could have deleterious economic effects in the short term, analysts say putting off or cancelling all of the measures without a long-term deficit deal in place would be equally dangerous for U.S. economic health.

What are the components of the fiscal cliff?

The following set of revenue and spending measures are set to expire or take effect at year's end, representing an acute fiscal consolidation that could be further intensified by a potential showdown over the debt ceiling:

over the debt ceiling:

Revenue Increases

• 2001/2003/2010 Tax Cuts & AMT Patch. This series of legislation, often referred to collectively as the "Bush tax cuts," will expire on December 31, 2012, raising all income tax rates (top will go from 35 to 39.6 percent), as well as rates on estate and capital gains taxes. The alternative minimum tax (AMT) will also automatically apply to millions more citizens.
• Payroll Tax Cut. The Social Security payroll tax holiday will expire December 31, raising the rate from 4.2 to 6.2 percent.
• Other Provisions. Several other policies such as the Research and Experimentation tax credit, many of which are typically enacted retroactively, are due to sunset at years' end.
• Affordable Care Act Taxes. Some provisions in the Obama health care legislation, including increased tax rates on high-income earners, are set to take effect in January 2013.

Spending Cuts

• Budget Control Act. The automatic spending cuts or sequester legislated by the Budget Control Act of 2011 will hit January 2. Half of the scheduled annual cuts ($109 billion/year from 2013-2021) will come directly from the national defense budget, half from non-defense. However, some 70 percent of mandatory spending will be exempt.
• Extended Unemployment Benefits. The eligibility to begin receiving federal unemployment benefits, last extended in February, will expire at year's end.
• Medicare "Doc Fix." The rates at which Medicare pays physicians will decrease nearly 30 percent on December 31.

Debt Ceiling

The debt limit, which sets the maximum amount of outstanding federal debt the U.S. government can incur by law, is currently capped at $16.394 trillion. Treasury could hit this borrowing capacity again sometime in early 2013. Analysts fear another protracted debate on the debt ceiling could bring repercussions similar to those that followed the debt battle in summer of 2011, which rattled markets and, according to a study from the Government Accountability Office, raised the cost of borrowing by $1.3 billion for FY2011.

How did it come to this?

The fiscal cliff is in many ways the culmination of a series of increasingly contentious fiscal showdowns between the two parties over the last few years. The most noteworthy, the debt-ceiling fight of August 2011, threatened the country's ability to meet its financial obligations and resulted in an unprecedented downgrade in the U.S. credit rating by Standard and Poor's. The subsequent failure of the bipartisan super-committee to reach a deal on $1.2 trillion in targeted budget savings over ten years unleashed automatic spending cuts for both defense and non-defense spending.

Most critics believe that the lack of a comprehensive, long-term deal on deficit reduction--one that addresses the need for major tax and entitlement reform--has propelled the use of short-term political expedients like the "doc fix" and other extenders. Meanwhile, the nation's debt soars on an unsustainable path, according to most projections.

Taxes and the role of government lie at the heart of the debate. Generally speaking, Republicans favor spending cuts as a primary means to achieve deficit reduction. Most have also publicly pledged to oppose all tax hikes, suggesting growth through tax cuts will increase revenue. Democrats typically believe tax increases should be part of any bargain to reduce long-term entitlement spending, and have generally supported greater reductions in defense spending.

This philosophical rift is on display in the debate leading up to the fiscal cliff. The two parties are divided over how to extend the Bush-era tax cuts, the largest single component of the fiscal cliff. Republicans, including presidential candidate Mitt Romney, are pushing for all cuts to be extended, while many Democrats, led by President Obama, would extend all cuts except for the wealthiest 2 percent of taxpayers. The fight over taxes is also very much part of the sequester debate (Politico), with Democrats pushing for more revenue as part of any deal to avert the drastic mandatory cuts.

What are the domestic consequences?

A $607 billion budget contraction in 2013 would likely send the United States into another recession in the first half of the year, according to the CBO. In such a scenario, analysts project real economic output in 2013 to grow at just 0.5 percent, resulting in lower taxable incomes and higher unemployment (one to two million).

International shipping giant UPS, which is often considered a bellwether for the business community at large, has already reduced its growth forecast for the second half of 2012 to just 1 percent, citing the climate in Washington (The Hill). "[Our] customers are concerned. They're not going to invest. They're not going to hire people. They're not going to stock inventory with all that uncertainty," said CEO Scott Davis.

A July report from Morgan Stanley (WashPost) similarly states the company is already experiencing cutbacks in business orders and hiring, and notes that "the negative impact of fiscal cliff uncertainty is becoming more widespread."

Moreover, a report from the bipartisan Committee for a Responsible Federal Budget (CRFB) suggests CBO projections "may underestimate the pain associated with the fiscal cliff since they do not fully account for the continued market uncertainty or the potential 'hysteresis' associated with continued long-term unemployment." In economic theory, labor market hysteresis occurs when persistently high unemployment fosters even higher levels of joblessness in the long term due to a number of causes (i.e., the skills of long-term unemployed diminish, thereby reducing the chances of becoming re-employed.)

What are the national security implications?

Automatic, across-the-board spending cuts of approximately $55 billion per year (through 2021) are scheduled to hit the Pentagon in January unless Congress steps in before the new year. Details of how the cuts will be enacted are yet to be fully worked out by the White House Office of Management and Budget, but some preliminary decisions have been made. In late July, President Obama exempted all members of the military from the potential cutbacks, an authority granted to the White House under the 2011 Budget Control Act (TheHill).

The decision will likely shift the burden of sequester cuts onto other areas of the Pentagon, including weapons programs. Defense contractors have already condemned the sequester as a potential "jobs killer." A fact sheet from the Republican-controlled House Armed Services Committee describes the looming defense cuts as an "unacceptable risk" that will "severely diminish America's global posture" and lead to the loss of over one million private sector jobs.

Similarly, the White House has described the potential cuts as "highly destructive to national security and domestic priorities, as well as to core government functions," and continues to push for a political compromise that would avert major cuts.

What are the global consequences if Congress fails to act?

The repercussions abroad would likely be significant if Congress is unable to at least temporarily stave off the acute onset of year-end tax increases and spending cuts. A July 2012 IMF report notes that massive fiscal tightening in the United States in early 2013 is a primary risk to global economic stability. Protracted gridlock in Washington would stall the U.S. recovery "with significant spillovers to the rest of the world," say experts. In addition, "delays in raising the federal debt ceiling could increase risks of financial market disruptions and a loss in consumer and business confidence."

What are the practical policy considerations?

Economists suggest a more prudent compromise would involve extending some current provisions either indefinitely or at least temporarily in order to avoid undercutting economic growth. The IMF advises U.S. policymakers to pursue tax and spending policies that bring down the 2013 deficit by a more modest 1 percent. At the same time, analysts say policymakers should forge a credible plan to impose a requisite amount of medium to long-term fiscal consolidation.

A host of public and private policy groups have proposed more than thirty different deficit reduction approaches that address the root problems of soaring U.S. debt: an aging population, longer life expectancies, and rising health care costs. A fiscal cliff dive, on the other hand, would significantly slash the deficit but would not address the fundamental drivers of long-term U.S. debt. A comprehensive deficit deal would map out a gradual schedule of targeted tax and entitlement reforms that businesses, individuals, and government agencies can plan for and adjust to.

The sooner such a plan can be worked out, the better, say analysts. "Failure to make the hard but necessary choices now on our own terms will lead to much harder and more severe choices later" at the behest of the markets, says CRFB. Continuing to grow the debt at unsustainable levels threatens to trigger a sharp increase in U.S. borrowing costs and further downgrades to the nation's credit rating. While global investors may continue to fund high U.S. deficits for several more years, recent experiences of several advanced economies in Europe indicate the unpredictability and speed at which fiscal crises can come.

What are the prospects for progress over the next few months?

Analysts say the approaching fiscal crisis at year's end offers Republicans and Democrats yet another opportunity to strike a balance between the short-term measures needed to feed the recovery and the medium to long-term policies that will stabilize and eventually lower the debt. But prospects for a significant political compromise that averts the fiscal cliff (Reuters) before the November election is highly unlikely, and some speculate that lawmakers may even wait until a Congress is seated in January before any action is taken.

The theory behind a deliberate cliff dive (CSM) would be to enable election winners to return to Washington with swollen coffers in January, hit the reset button, and put together a new package of policies they can frame as "tax cuts." Part of the recouped revenue could also be used for deficit reduction. Some think policymakers are already telegraphing this strategy in order to inoculate the markets. Even if there is a temporary crisis, it would likely only last a couple months before recessionary pressure forces Congress into action, some analysts say.

Expectations for a pre-election deal that would put the brakes on the $1.2 trillion in automatic budget cuts are also quite low. While both parties have expressed opposition to the "meat axe" approach to deficit reduction (WashPost), they remain divided on a workable alternative. However, similar budget sequesters in 1988 and 1990 (PDF), which were reduced or erased by subsequent legislation, may offer insight into a likely outcome.