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3Qs: Is America headed over the fiscal cliff?

The so-called “fiscal cliff” facing America refers to the estimated $700 billion in total spending cuts and tax hikes for next year alone and is set to take effect in January with the onset of several factors. These include the expiration of the Bush-era tax cuts, the expiration of unemployment benefits and massive cuts in domestic and defense spending triggered by the Budget Control Act of 2011 following a political deal on the debt-ceiling crisis. Ever since, politicians have yet to come to a compromise on a budget deal in order to avoid falling off the cliff.

Last week, House Speaker John Boehner declared that there had been “no substantive progress” on a new deal, though Republicans on Tuesday countered President Obama’s latest proposal. Here, William Dickens, University Distinguished Professor of Economics and Social Policy, explains what steps the government must take to prevent the U.S. from going over the fiscal cliff.

Why has the fiscal cliff reached this point and what are the most likely scenarios in which America will address the problem?

The fiscal cliff was constructed as a solution to the debt-ceiling crisis in the summer of 2011. Legislation was passed imposing the January 2013 deadline for a full solution to the budget problems or automatic budget cuts would go into effect. This will coincide with the ending of the Bush tax cuts, the reduction to social security payroll taxes and extended federal unemployment benefits. The idea was to make it so onerous not to have a budget deal that the Democrats and Republicans would be forced to compromise. But it seems it may not have been onerous enough. Many people are now concerned that a deal can’t be cut because the two sides have been at loggerheads for so long and because there isn’t enough time to complete a deal given how complicated it is to change the country’s tax codes and spending plans.

Looking forward, one scenario involves doing the near impossible: to complete a budget deal in a month, when it would normally take many months and when there still isn’t even agreement on the basic principles of a deal. The second would be to kick the can down the road to provide more time to come up with a compromise, but, again, there would still need to be agreement on core principles. The third outcome is going off the cliff; when all the contractionary changes hit in January we can expect the economy to slow and even go back into recession if a deal isn’t reached soon after the first. On top of that, we’d be facing another fight over raising the debt ceiling and with that, the possibility of a federal government shutdown of some form because it wouldn’t be able to borrow the money it needs to operate.

Which option do you think is most likely?

I think we’re going over the cliff. I’m not certain of it, but I’d say it’s more likely than not at this point.

The economy has been improving, and we could have expected rapid growth next year if it were not for the threat of these fiscal fits. The housing market is finally coming alive. That was the big drag on the economy for several years. If we go over the cliff, I’d guess we’d push ourselves back into a recession, though not a severe recession. The Congressional Budget Office forecasts a relatively small decline in GDP over the next year if the spending cuts and tax increases go into effect.. But the danger is that this could be another Lehman Brothers moment that could upset the financial markets. The U.S. could be seen as not being able to govern itself and this might scare people off from buying our bonds. With instability in the financial markets, there’s always the possibility of a panic like we saw in 2008, which could lead to another depression.

This issue has no doubt been politically charged. President Obama has railed against Republicans for their opposition to tax hikes, while the GOP has criticized the administration for not proposing specifics on spending cuts. Politics aside, what steps are necessary to begin fixing this mess?

Any reasonable solution to the budget deficit requires both cutting spending and raising taxes. There’s no getting around it, unless you want to radically transform American society, which I doubt most people want. In particular, it makes sense to concentrate tax increases at the top of the scale. Those rates have come down enormously over the last 30 years, while in that time inequality in pretax earnings has grown. Pretax earnings for the very well off have grown considerably relative to others, while top income tax rates have fallen from the 90 percent rates that prevailed in the 1950s and 1960s to 35 percent on earned income today.

On the other hand, something must be done to contain medical expenses. That’s the really big problem with our country’s expenditures. Neither party will want to do this by itself. There must be some across the board agreement, which will likely be unpopular. That could include increases in taxes that pay for Medicare and Social Security and hard ceilings on the amount of money spent on those programs. If we’re going to have a healthcare system that’s substantially funded by the federal government, then there needs to be limits on how much the government has to spend on that program.

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