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The Cliffhanger from South of the Border


Unless the U.S. Congress reaches a compromise before December 31, the U.S. budget will go off the “fiscal cliff.” The news media are increasingly fostering a sense of impending doom worthy of an Indiana Jones flick. What is this “fiscal cliff”? What would it mean for the U.S., for Canada and for Canadians with business or investments in the U.S.? What are the politics at play and likely outcomes? This is a big one and worth paying attention to.

The “fiscal cliff” consists of a combination of expiring tax measures, most of them loosely referred to as the Bush tax cuts, and draconian spending cuts, referred to as sequester, set to go into effect on January 1, 2013. This “doomsday” deadline approach was agreed to in the Budget Control Act of 2011 during the last budget and debt crisis. When and if these measures kick in, tax rates will rise significantly and spending will be slashed. Taken together, these measures would represent an austerity program along the lines of those being followed by European countries like Greece, Spain, Portugal and the U.K. Many economists estimate that if this austerity program is implemented and pursued, the U.S. gross domestic product in 2013 could fall by as much as four percentage points, hurling the U.S. economy into recession with an increase in the already high unemployment rate of over 1 percentage point to well over 9 percent. A few economists argue that such austerity is required to deleverage the overhang of heavy sovereign debt in the U.S. and is just as necessary in the U.S. as it is in Europe and would therefore be salutary in the long run. Most commentators and the entire political class, on the other hand, view the fiscal cliff as a cataclysm or “taxaggedon” to be avoided at all costs.

Some of the key tax measures set to expire include:
  • A capital gains tax rate of 15 percent, generally, would climb to 20 percent
  • The rate of tax on dividends, currently pegged to the capital gains rate, would revert to ordinary income rates of up to 39.6 percent
  • Tax rates on ordinary income would climb from a maximum individual rate of 35 percent to 39.6 percent for taxable income over USD $250,000 for a couple, with another bracket at 36 percent for taxable income over $140,000 for a couple
  • The estate tax will see its top rate climb from 35 percent to 55 percent and its basic exclusion amount drop from over USD 5 million to USD 1 million
  • Various “patches” for the alternative minimum tax would expire, meaning that millions of Americans will have to pay alternative tax for the first time
  • A 3.8 percent Medicare surtax on top earners connected to health care reform often called “Obamacare” will come into effect
  • A 2 percent reduction in the employee withholding at source intended as stimulus will expire with Social Security payroll tax rising from 4.2 percent to 6.2 percent
  • Important corporate provisions like the research credit would expire

The steep spending cuts that would ensue from going off the cliff result from the Budget Control Act of 2011, which was a key element of the compromise needed to overcome the impasse in 2011 regarding the debt ceiling. It calls for massive reductions in years 2013-2021. These would severely affect the military budget as well as domestic social programs other than Social Security. Extended unemployment benefits, enacted in the wake of the Great Recession and regularly extended, would expire. The fees paid to physicians treating Medicare patients would drop by nearly 30 percent.

To make matters worse, Congress will likely need to face the prospect of the U.S. national debt bumping up against the current authorized ceiling in the first quarter of 2013. Back in 2011, Congress only averted default on U.S. Treasury debt by agreeing to the legislation that creates the risk of the fiscal cliff now. Many predict much strife and contention and gnashing of teeth in Congress, once again, when the time to increase the ceiling on the national debt comes up for consideration. In fact, some consider this a perfect storm that is actually part and parcel of the fiscal cliff in the larger sense.

As of this writing, Congress does not appear to be on the verge of reaching a grand compromise. President Obama and the Democrats insist that the recent elections have proved that the American people favour an increase to tax rates for the wealthy, i.e., those earning over USD 250,000 of taxable income. The Republicans counter that revenue can be raised by closing tax loopholes and insist that spending cuts must be made permanent and inviolate since Congress has routinely failed to adhere to planned cuts in the past. Negotiations are likely to continue and even intensify as the Christmas recess approaches. If no compromise has been found by then, Congress may be called on to reconvene between Christmas and the New Year.

Here are just a few of the many possible scenarios about which commentators have speculated. Congress may resort to stop-gap, partial compromises such as agreeing to a short-term extension of some Bush tax cuts but not others, e.g., extending lower-rates for the middle class but not those at the top or extending the patches for the alternative minimum tax or the Medicare “Doc Fix.”

On the other hand, some have speculated that going over the cliff, then addressing the mess in the New Year may paradoxically facilitate compromise. Under this theory, after the tax rates have risen for everyone on January 1, the Republicans would be in a position to claim that by agreeing to subsequent tax relief for the middle class but not top earners, they didn’t actually agree to raising taxes (a key element of the current Republican credo) but only lowering taxes for the middle class. Similarly, if some of the steep cuts to spending are restored for some social programs after going over the cliff, Democrats can claim that they helped to restore spending rather than cut it. One commentator has referred to this political dance as kabuki theatre in which the policies are based on political posturing much more than any actual policy. I prefer to think of it as sophistry.

I can think of at least two significant risks to rappelling down the fiscal cliff in this way:

  • The first is the real question of whether the new Congress will be any better than the current Congress at finding real compromise and leaving behind cynical posturing. In other words, the grand compromise may be just as elusive in 2013 as it has been in recent years.
  • A second significant risk is that financial markets may not have already fully discounted the likelihood of going over the fiscal cliff as some believe and there may yet be room for a sudden and severe reaction with economic and political consequences of its own.

Finance Minister Flaherty and other Canadian officials have already warned that the Canadian economy could be adversely affected if the U.S. economy suffers a blow as result of the fiscal cliff. Canadians who receive employment or business income from the U.S. could be affected by an increase in tax rates. Canadians who have a capital gain on the sale of U.S. real property could be affected by an increase in capital gains rates. However, some Canadians, who remember the years of belt-tightening when Paul Martin was Finance Minister, may wonder if the time has come for the U.S. to tighten its belt, one way or the other.