Thursday, 14 February 2013

Fiscal Cliff – A Bitter Medicine

“the one thing that I think, hopefully, in the new year, we will focus on is seeing if we can put a package like this together with a little bit less drama, a little less brinksmanship, not scare the heck out of folks quite as much.” 
                                                                                               - Barack Hussein Obama II
This was a statement of 44th President of the USA on the New Year day of 2013. The statement was about the most awaited “Fiscal Cliff Deal”.
US Treasury borrowed trillions of dollars over the decade from the foreign investors to finance two long wars and promote economic growth by fiscal stimulus. The Federal reached the current debt limit of $16.39 trillion USD. Since the Federal government has reached the borrowing capacity, the US Treasury is taking extraordinary measures to raise money. The Bipartisan Policy centre forecasts that the debt ceiling would have to be raised between $ 0.73 trillion USD and $ 1.25 Trillion USD to extend the government’s borrowing capacity through 2013.
If Congress cannot raise the debt limit, then the Fed should reduce its spending or increase tax. If the government is unable to take these actions it would force to default or delay some of the financial commitments. To avoid this, the Fed has to reduce the budget deficit. Budget deficit decreases with decrease in the government spending or decrease in transfer payment or increase in tax revenue. This is the root for discussion on Fiscal Cliff.
Fiscal Cliff is a combination of expiring tax cuts and decrease in the government spending across various departments aiming at sharp decline in budget deficit. The origin of the word fiscal cliff is ambiguous because some refer it to Goldman Sachs, Federal Reserve Chairman Ben Bernanke etc.
The most important component of the fiscal cliff is the Bush Era Tax cuts which include lower tax rate and reduction in dividend and capital gain taxes. These tax cuts have expired at the end of 2012. The effect of this would be increase in long term capital gain tax rates from 15% to 20%, and qualified dividend rates from 15% to individual marginal tax rate. Gift Tax exemptions and tax on estates would also be affected.
Another major component discussed in Budget Control Act of 2011 includes many factors. The temporary Social Security Pay roll tax has also expired at the end of 2012 and increased the tax from 4.2% to 6.2%. Fiscal cliff was proposed to include across the board spending cuts, reversion of Alternate Minimum Tax (AMT), expiration of measures delaying the Medicaid sustainable growth rate, expiration of federal unemployment benefits. Also many itemized reductions were to phase out; child tax credit, earned income credit and American opportunity credit were to be reduced. The proposed tax brackets were 15%, 28%, 31%, 36% and 39.6% as against the existing 10%, 15%, 25%, 28%, 33% and 35%.
According to this proposal the Congressional Budget Office forecasts the budget deficit to fall from $1.1 Trillion to $0.2 Trillion USD by 2022. However it also estimates the GDP and disposable income of the people to decrease leading to a loss of 3.4 million jobs increasing the unemployment rate by roughly 1.2%.
The Democrats favoured the increase in taxes while the Republicans favoured more spending cuts. However they were ready to compromise on many critical issues to bring the US economy to a normal state.
The actual fiscal cliff varied from the proposed in many aspects. It made permanent the Bush tax cuts for individuals earning less than $400,000 USD per year and couples earning less than $450,000 USD per year. It brought back the top tax bracket from 35% to 39.6% which was present before the Bush Era.
The deal cuts $737 billion from fiscal deficits in the coming ten years. This is very small compared to the deficit that USA would be accumulating during the same period.
This calls upon for the implementation of the second dimension of the fiscal cliff i.e. decreases in government spending and transfer payments. But the bill extends the government spending for two months to delay the threat of sequestration, a series automatic across the board cuts in Federal spending.
The above deal has impact on many groups. The economic winners and losers are starting to become clear. Some of the many groups who would be winners are NASCAR which gains $70 Million USD due to the extension of Tax Breaks Law, milk drinkers due to the nine month extension of Farm Bill, semi wealthy people who earn between $250,000 to $400,000, the long term unemployed as Obama has pushed the benefits to 99 weeks, those wealthy, elderly bachelor uncles because the Democrats proposed 55% tax on the Gits which were more than $1 Million but now Gits under $ 5.12 Million are free from tax.
The losers would be very wealthy people since the marginal tax rate for these people has increased and also there is an increase on capital gains and dividends. The next sufferers being the Hospitals as the Taxpayer Relief Act prevented the existing 27% cuts on treatment.
The entire discussion brings us to a kind of comparison between the European Union and US government acts to stabilize the economy. The first of the similarities would be the addiction of kicking down the can as far as possible as seen when the Fed postponed implementation of spending cuts. The second clear similarity would be finding temporary solutions instead of correcting the root causes of the deficit. The US is not concentrating on the “entitlement” reforms or rationalizing the US’s complex tax code because both the Democratic and Republic parties are driven by their respective party’s extremists. The third parallel is that the politicians in both the regions are not being honest to the voters and not telling them what it takes to come out of an economic crisis.

Article was published in Volume 20 of Finance magazine of IBS Hyderabad "The Financial Bulletin".

This article is written by A Sindhuja and Y. VenkataAchyuth Kumar (PGDM student of 2012-14 batch of IIM Raipur). 


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