Monday, 19 November 2012

Do we need to fear the fiscal cliff? I.

While Barack Obama has won the 2012 presidential election on November 7th, allowing him to remain president for a second term, he may not cheer for long. The "fiscal cliff", as named by the FED president Ben Bernarke is inevitably approaching, dividing Democrats and Republicans alike - but what exactly is the fiscal cliff? And should it be feared? This short essay will aim to provide answers to these questions, split in two parts; today's post will examine the status quo, while tomorrow we will examine the predicted effects of possible scenarios.


The fiscal cliff, technically put, is the set of changes predicted to be caused by the expiration of the so-called "Bush era tax cuts", a series of measures imposed in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), extended by the Budget Control Act of 2011 (BCA). Without a further extension, these measures are bound to expire by 1 January 2013, leaving the US public budget in a substantially different shape than before.


In order to assess the effects of such a policy change (or rather, the lack of it), we'll need to assess:
a) The current effects of the current tax cuts on the American economy - the status quo;
b) the effects of abolishing the tax cuts;
c) the effects of keeping the tax cuts. 
In this analysis, we will concentrate on the two extremes of complete abolition and complete keeping up of tax cuts; the current antagonism of the Democrats and Republicans suggests that such an assumption is not far-fetched. Hence in order to determine what policy should the politicians choose, we only have to choose between these two options; a careful analysis of the pros and cons of each stance brings us closer to whether there could be an ideal compromise, maximizing the utility of the decision both for the state (deficit-wise) and the citizens (whatever that may mean; we will discuss the effects for individual citizen groups later).

Status quo

While the effects of what will/what would happen after the cliff cross are quite well documented, but the current situation is rarely assessed. This is so because while one side (the need for a balanced budget and the US deficit history) is well documented, but the individual effects on the population are very diverse, and they affect different population groups in different ways. However, given that the tax cuts are keeping a mildly progressive taxation system from becoming more progressive (that is, that people with more money pay relatively more taxes), the current situation favours the more well-off. Just how much is once again difficult to quantify; that being said, the EGGTRA lowered income tax rates for all groups with an average of 3%, while the JGTRRA lowered tax rates on capital income. As a result, federal income has decreased, hence, federal debt has grown; the graphic below displays historic values of US federal debt. 

Click to enlarge. Source: Wikimedia

As it can be seen above, government deficit did rise starting in the 2000's; however, the biggest part of debt growth only came in 2008, with the financial crisis(and the implementation of TARP and other measures). 
Consequently, it weren't the tax cuts which caused the debt crisis; but in a wider, financial sense, it may now be better for the American economy to abolish them (to help lower the debt). 

Searching for answers

Essentially, the questions American politicans now face are the following.
A) Will the abolishment of tax cuts bring down federal debt?
B) Would doing so hurt the economy? How?
C)  Are the current debt levels destructive for the US economy?
D) If C) and B) is true, which one is better - a debt relief in exchange for a temporarily hurt economy, or
sustaining the status quo, and watching debt levels increase?

In our next post, we will try to provide answers to these questions, and answer the title question - see you tomorrow. 


  1. Thanks, Anthony. Do feel free to ask any questions, follow the blog and describe to the RSS channel. The second post can be found at: