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Why the fiscal cliff deal offers little to celebrate

obama fiscal cliff
AP Photo/Charles Dharapak
You’re welcome, America.
  • Gwynn Guilford
By Gwynn Guilford


Published This article is more than 2 years old.

This item has been corrected.

The last-minute deal to postpone America’s fiscal cliff has markets rejoicing: March futures for the Dow Jones Industrial Average bounced 1.9%, by last count, while the Euro Stoxx Index soared 2.4%. But that joy is short-termist. Though it warded off the worst, the deal institutes levels of austerity that, unlike economies across the Atlantic, the US has so far avoided.

In total, the crimped consumption power resulting from Congress’ new plan will cost the US economy somewhere in the range of 1.30%-1.75% GDP growth this year, according to estimates by Cullen Roche and Brad DeLong. Of course, that’s vastly preferable to the 4%-5% hit that the full impact of the fiscal cliff would have entailed. But for a country clawing its way back from a recession, it’s grim news.

Most immediately worrisome is that, while lawmakers agreed to prolong Bush-era income-tax cuts for households earning less than $450,000 a year—all but the highest-paid 0.7% of the population—they let a cut in the payroll tax (which pays for social security) expire. Though doing so will close the 2013 budget deficit by some $126 billion, it means that 160 million Americans—including two-thirds of the lowest quintile of earners—will see around $600-$2,000 skimmed off their paychecks this year.

That exacerbates a trend of falling wages in the past few years, and is particularly worrying given that consumer spending is a critical engine of the US economic recovery. In fact, Goldman Sachs’ Jan Hatzius expects that the expired payroll tax cut alone will drain 0.6% off 2013 GDP growth, in the form of reduced consumption.

And while this does help cut the deficit, it’s not by that much. Extending the Bush tax cuts for all but 0.7% of households will rustle up a measly $600 billion over a decade. The president’s original plan, in which the threshold for raising income tax was $250,000, or around 3% of households, would have raised $950 billion. (Letting the tax cuts return to their pre-Bush levels across the board would have saved $1.9 trillion, but of course at the cost of hurting consumers in the pocket.)

In agreeing to these terms, the Democrats seem to have taken further tax hikes on the wealthy off the table, at least for a while, even though these are politically popular. The implications of this are twofold.

First, a larger share of reductions in the budget deficit will have to come from spending cuts—by far the more contentious side of the negotiations. The current deal postponed the spending cut showdown for two months, which is also roughly when the US government will have exhausted its “extraordinary measures” to avoid exceeding the debt ceiling (which it formally hit on Dec. 31). That makes yet another vicious partisan fight almost inevitable. The president has a trump card here: the automatic spending cuts or “sequester” that will take effect if no deal is reached include a deep cut to defense spending, which the Republicans would hate to see happen. But given how hard it was to reach an alternative deal on Dec. 31, it’s not clear why it should be any easier on Feb. 28.

Second, it means that any extra revenues have to come not from higher income-tax rates but from long-overdue tax reform. This means simplifying the tax code and eliminating nonsensical loopholes like the tax break on mortgage interest. Such loopholes generally benefit those who can afford to navigate them, so getting rid of them is another way to address the yawning income-inequality gap. Obama said in a speech on Dec. 31, as the final details of the fiscal-cliff deal were being hammered out, that tax reforms to increase revenue would have to be part of any future fiscal deals, and he may use the threat of the sequester to force Republicans to agree to some. But once again, it’s hard to imagine the two sides agreeing something in the next two months that looks anything like the thoughtful, comprehensive reform the country needs.

Correction: An earlier version of this item said that Dow futures were up 248%; it should have read 248 points. This was corrected to 1.9%.

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