It is telling that, according to a recent survey by Macro Risk Advisors, the biggest threat facing U.S. investors isn’t a meltdown in the eurozone, or a crash in China, or even a misstep by the Federal Reserve. In fact, their biggest fear is the uncertainty engendered by election season, and the “fiscal cliff” over which the United States is set to hurtle come January 2, 2013.
The cliff in question is a $607 billion combination of tax increases and spending cuts, and is the result of failure by Congress in 2011 to reach agreement on how to reduce the federal deficit. Without political intervention, it will come into force just as our New Year’s Eve hangovers start to wear off. But how bad could it be?
According to the Tax Policy Center, taxes would rise by more than $500 billion in 2013, as almost every tax cut enacted since 2001 would expire. Average marginal tax rates would rise by 5 percent on labor income, by 7 percent on capital gains, and by more than 20 percent on dividends. Almost every American will be hit. Most will feel the impact of a rise in payroll taxes and higher income tax rates, with middle-income Americans facing an average tax increase of almost $2,000. Those on low incomes will suffer the withdrawal of tax credits, while high earners will face punitive taxes on high-end health care plans and a squeeze on their investments.
You don’t have to agree with President Obama’s former advisor Christina Romer-who estimates that increasing taxes by 1 percent of GDP leads to a 3 percent reduction in GDP overall-to see that tax rises of this magnitude are likely to be very damaging, especially in the context of an anaemic and largely jobless economic recovery.
But even avoiding these tax rises wouldn’t leave the U.S. with a rational, pro-growth tax system. Policy makers desperately need to comprehensively reform the code, eliminating a maze of exemptions, deductions, and special favors, while cutting rates across the board. Unfortunately, that’s not how Washington works.
When it comes to the spending cuts, the story is rather different. Here, at least, the threat to U.S. economic health is vastly overstated. The lion’s share of the scheduled cuts come courtesy of the Budget Control Act of 2011, which mandates automatic cuts of around $109 billion a year, starting on January 2 and continuing until 2021.
That sounds drastic, but should be put in context. The federal government has run a trillion-dollar deficit four years in row, and currently borrows 30 cents of every dollar it spends. It barely raises enough revenue to cover “non-discretionary spending” on things like pensions, debt interest payments, and health care for the poor and elderly-let alone to fund national defense (where America spends five times as much as its nearest competitor, China) and other government programs. Such profligacy may be manageable now, with treasury yields at record lows, but bond markets can be capricious. The U.S. is storing up enormous trouble for its future, even before you consider the impact of inexorably rising health care costs and an aging population.
Moreover, these automatic cuts are calculated against a baseline of projected spending increases. As Mercatus Center economist Veronique de Rugy has pointed out, “After the initial cuts, spending will grow by $1.65 trillion, as opposed to $1.8 trillion, between 2012 and 2021.” Defense spending-the target of half the automatic cuts-will initially fall to 2007 levels (in inflation-adjusted terms) and then return to 2012 levels by 2018. So while these cuts will undoubtedly pose an administrative challenge, they are hardly the public sector apocalypse-or the open door to America’s enemies-that their critics would have you believe.
Indeed, the problem with the fiscal cliff spending cuts is not that they go too far, but that they don’t go nearly far enough. They entail no meaningful reforms to unaffordable and outdated entitlement programs at home, and they impose no serious restraint on America’s trigger-happy interventionism overseas. They’re a start, but that’s all. In the long run, the U.S. needs to do the same thing as every other Western state: Radically re-think government from the ground-up and question absolutely everything.
Fiscal cliff or no fiscal cliff, the 112th Congress has shown itself spectacularly ill-suited to that task. One can only hope its successor will do better.
Tom Clougherty is managing editor at Reason Foundation. This article was originally published at reason.com. An earlier version appeared in City AM, a London-based business newspaper.