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Fiscal Plunge? It Will be More of a Bungee Jump

Irwin M. Stelzer

The world is watching. It would be “very bad” if the negotiations fail. So spake Tony Blair. Perhaps. Instead, a deadlock might be a non-event, and we should stop worrying about a “plunge over the fiscal cliff.” It is not a cliff, it has very little to do with US fiscal policy, and we are not about to see a “plunge.” A cliff, says my dictionary, is a steep rock face, especially at the edge of the sea, made by Mother Nature, immutable as the white cliffs of Dover. The fiscal cliff is made by man and can be eliminated as easily as it was created.

In any event, even if a deal is cut, it will not address the long-term fiscal problem faced by America.

Nor are we in danger of a plunge, in the style of Thelma and Louise. More a bungee jump, which is a leap from a high place while connected to an elastic cord. Thrilling, rather like the budget negotiations, but when done correctly, not fatal.

We are witnessing a battle of two men—one fighting to preserve his ability to transform the American economy further, the other battling to keep his job. President Barack Obama dearly wants to leave a legacy of a society in which incomes are more equally (not necessarily equitably) distributed, subsidised green energy sources replace a diminished production of fossil fuels, and the regulations for implementing Obamacare and financial restructuring are in place. He needs the enthusiastic support of his congressional party but can no longer offer Democratic candidates coat-tails to which to cling when their election campaigns roll around in 2014. So he woos them by taking a hard line in the current negotiations.

Facing the president is the speaker of the House of Representatives, John Boehner. When the new Congress convenes in January, the Republican majority can re-elect Boehner or replace him if they feel he has conceded too much to the president. That constituency includes a large number of Tea Partiers who have pledged that they will never, ever raise taxes. Boehner has persuaded most of them that“revenue enhancement” achieved by plugging loopholes rather than raising tax rates is consistent with that pledge. That is as far as he can go. Most congressional Republicans would rather see the negotiations fail than concede the increase in the tax rate paid by higher earners, the very thing the president promised to impose during the recent election campaign, and which he fervently believes is essential to “fairness.”

So to have any chance of getting his programme through Congress, the president must insist on the rate rise that will cost Boehner a trip to the backbenches if he, to use the word of his congressional colleagues, caves. All of which makes it unlikely, although not impossible, that a deal will be struck to avoid triggering tax increases and spending cuts at year-end. Indeed, an increasing number of congressmen believe that this bungee jumping would be bracing. No matter: the effect on the economy of either a compromise or failure to reach one will not be very different.

In fact, the president holds all the high cards. If no deal is reached, all taxpayers will face an increase in income tax rates—from the Bush levels of 10% to 15% for the lowest earners, and from 35% to an effective level of 43% for the highest. Taxes on capital gains will rise from 15% to 20%, and on dividends from 15% to as high as 39.6%. These increases will be accompanied by an additional Obamacare tax of 3.8% on the investment income of high earners. That’s when the elastic rope comes in. The president immediately introduces a bill to lower tax rates to Bush levels on all but the high earners, and dares the Republicans to vote against it. Result: rates on high earners are up, rates on 98% of taxpayers are back where they started. Campaign promise fulfilled, egalitarian ideology satisfied.

Which leaves the question of the spending cuts called for in fiscal cliff legislation. Reductions in military spending would suit the president and his friends in Congress just fine. They say the cuts won’t trigger a recession because they would be phased in gradually by an industry that is already reducing investment as it prepares for the withdrawal from Afghanistan and four years of a government controlled by a president who feels the nation has better uses for its money than to spend it on defence. To offset some of the spending cuts, the president is demanding $50bn—Stimulus Mark 2—for infrastructure projects. And his fellow Democrats are urging that any new tax revenues be used to fund new spending, rather than go towards reducing the deficit. So fiscal tightening will not be on a Grecian scale.

Although I do worry about the effect of policy uncertainty, my guess—it is only that—is that all of this will not produce a recession in an economy that just might be stronger than many analysts think: housing and car sectors up, cheaper energy improving competitiveness and 147,000 private-sector jobs created in November.

The increase in taxes on dividends will not affect shares held by pension funds, insurance companies, foreigners, or families earning less than $250,000. Besides, by year-end more than 220 companies will have paid dividends originally scheduled for 2013, beating the tax-rate increase. The scheduled rise in the capital gains tax is probably insufficient to have much effect.

I should point out that other good economists believe that a plunge over the cliff would hit the economy, hard. One such is John Makin, a scholar at the American Enterprise Institute. Makin believes that, at minimum, the drag created by a failure to reach a deal will throw the economy into recession for all of 2013. This is a grimmer forecast than that of the Congressional Budget Office, which expects a short, shallow dip.

Meanwhile, the prospects for a longer-term, bipartisan attack on unaffordable entitlements by the new Congress are fading, while the Fed still prints money. The day of reckoning will come, but it is not yet at hand.

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