The Fiscal Cliff

It is hard to ignore the big news of the moment, which is the US fiscal cliff. For those who are not from the US, this is a summary from the Congressional Budget Office (CBO):

• A host of significant provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312) are set to expire, including provisions that extended reductions in tax rates and expansions of tax credits and deductions originally enacted in 2001, 2003, or 2009. (Provisions designed to limit the reach of the alternative minimum tax, or AMT, expired on December 31, 2011.)
• Sharp reductions in Medicare’s payment rates for physicians’ services are scheduled to take effect.
• Automatic enforcement procedures established by the Budget Control Act of 2011 (P.L. 112-25) to restrain discretionary and mandatory spending are set to go into effect.
• Extensions of emergency unemployment benefits and a reduction of 2 percentage points in the payroll tax for Social Security are scheduled to expire. 

From the same article, this is the projection of the CBO:

CBO’s Baseline: Taking into account the policy changes listed above and others contained in current law, under CBO’s baseline projections:

• The deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4.0 percent of GDP), almost $500 billion less than the shortfall in 2012.
• Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013.
• Because of the large amount of unused resources in the economy and other factors, the rate of inflation (as measured by the personal consumption expenditures, or PCE, price index) will remain low in 2013. In addition, interest rates on Treasury securities are expected to be very low next year.

 The current situation is summarised here (sorry, it's long):

WITH the clock ticking toward a New Year's time bomb of huge tax increases and spending cuts, US politicians are working to keep America from tumbling off the so-called fiscal cliff. 
 
The stakes in the game of holiday-interrupting brinkmanship are huge. Economists agree the $US500 billion ($A484 billion) in fiscal pain due to kick in as soon as the new year starts will stifle the gathering US economic recovery and send the United States back into recession, spelling bad news for the global economy as well.

Aides to leaders of the Democrat-controlled Senate worked behind closed doors on Saturday morning to fashion a deal palatable to both Republicans, who control the House of Representatives, and the Democrats.

A senior Republican aide said "discussions are under way". He added that details of any deal will not come out until leaders brief their caucuses on Sunday.

Both chambers would need to pass a deal by New Year's Eve. They thus have three days to get done what has eluded the White House and Congress for weeks, and will interrupt their year's end vacation in the process.

As negotiations proceeded, President Barack Obama urged Congress to protect the middle class from higher taxes and lay the groundwork for economic growth.

"We've got to do what it takes to protect the middle class, grow this economy, and move our country forward," Obama said in his weekly radio and internet address.

"Leaders in Congress are working on a way to prevent this tax hike on the middle class, and I believe we may be able to reach an agreement that can pass both houses in time," he added.

Obama met with top congressional leaders on Friday and said Senate Democrats and Republicans would work overtime this weekend to try to head off the fiscal cliff.

The president, sensing a mandate from his re-election last month, wants to raise taxes on the rich but exempt the middle class. Republicans want only to close tax loopholes to raise revenue and demand significant spending cuts in return.

But if nothing is done by the deadline, all taxpayers will see an increase.

The first point to note is the 'cliff' metaphor. It frames the spending cuts and tax increases in terms of something scary; falling off a cliff leads to harm. The use of this metaphor is of itself an argument, and and argument that says the tax increases and budget cuts are a bad thing. Framing the changes in this way also becomes an urgent call to action, and that is exactly what is taking place (albeit with no success so far). Another problem with the metaphor is that it is not actually a cliff:

For one thing, it isn't really a "cliff." The impact of the tax hikes and spending cuts will be felt gradually, over several months, so there will "be plenty of time beyond January 1, 2013 for things to get worked out."

In short, the term 'cliff' is a distortion of the actuality of the situation. The most worrying aspect of this distortion is that it is driving action, and driving hurried action. Although I am completely in favour of action to reduce the deficit, this is absolutely not the way to take action. Instead, what should be taking place is a more measured look at spending and taxation, and how the activity of government is prioritised and how it might be reformed. This is a question of what constitutes the core functions of government, and elimination of non-core functions. I do not give my view here on what those core functions are, as this is a political question, but it is a question that needs to be answered. Having answered the question of core functions, the functions thus identified have to be given priority, and hard decisions made on the allocation of finite resource to each core function, and how the underlying purpose of the function can be retained, whilst reducing the costs of the function (regular readers will have seen examples I have given for the UK where I have taken this approach, e.g. here). It is also about what share of the wealth of a country will be given over to the use of the government, and accepting that the government must operate from tax receipts and not use borrowing to dishonestly bribe the electorate with tax breaks now at future cost and provision of services funded with borrowed money at future cost.

The other point that needs measured examination is the US tax system, which is notoriously complex and unwieldy. Again, the US needs to go back to the core, and ask what taxation is really supposed to achieve. I have written on the UK tax system, but much of what I have written would certainly apply to the US. In particular, just as in the UK, the US tax system has become a political policy tool, rather than a system for collecting x amount of revenue. All taxation systems are in some respects political, but the politics should be limited to the distribution of the burden of taxation, rather than a political tool used for wider political goals. Although the arguments over the 'cliff' are focused on questions of distribution, the real problems of the current system's complexity and distortions are ignored.

Indeed, the entire debate over the 'cliff' is one of political grandstanding, rather than any serious attempt to address the real question that needs resolution; how can finite resource be best collected and used in order for government to achieve its core functions? The word 'cliff' is a problem, as it drives urgency that was never there, and plays to the desire for political grandstanding. I want to be clear here, that I believe that there is an absolute necessity to cut the deficit, but this is not the way to do it. It is urgent, but it is not 'fiscal cliff' urgent. All the term fiscal cliff has achieved is to drive out the mature debate that is necessary to enact real reform. This suits the politicians. Rather than take hard decisions, they can bury issues in messy compromises within the current system instead of facing the more fundamental and difficult questions.

Update: I nearly forgot. Thanks for the paypal donations from several readers, which I am guessing were inspired by Christmas. I would also like to wish all the readers a happy New Year!