The series of tax increases and government spending cuts that had been due to come into effect on 1 January would have been a hammer blow to the US economy
For a start, the expiration of decade-old tax cuts championed by former President George W Bush, along with later fiscal goodies such as an extension of unemployment benefits, would have caused a sharp decline in take home pay for most Americans. An American family with an income of $70,000 a year, for example, would have seen an additional $4,000 vanish from their paychecks - equivalent to a 6% salary cut.
Add in the effect of automatic cuts in government spending, and the fiscal cliff would have sucked about $600bn from the economy in 2013.
In averting this outcome, American politicians have dodged an economic bullet. The non-partisan Congressional Budget Office estimates that going off the cliff would have caused the US economy to contract by 0.5% in 2013 - against expected growth of between 2.3% and 3%.
Ideally we would have liked to see Congress avoid immediate damage to the fragile economy while addressing the long term problem of over-spending
The deal arranged by Congress doesn’t avoid all of this pain. Most Americans will be hit by higher payroll taxes – removing about $1,000 a year from the average paycheck. Meanwhile high fliers earning over $400,000 a year will see their top rate of tax revert to the pre-Bush level of 39.6% from 35%.
Still, this milder package will raise taxes by just $500bn over the coming decade. As a result the CBO still thinks the US economy will grow by around 2.5% next year. That should mean that the steady fall in US unemployment will continue.
Now for the really bad news. The US Congress has once again demonstrated a worrying inability to get to grips with the nation’s deteriorating public finances. Congress needed to raise about $3trn over the next decade merely in order to stop the US debt-to-GDP ratio from rising from an already excessive 75% of national income. The latest deal raises just a sixth of the amount needed.
“Ideally we would have liked to see Congress avoid immediate damage to the fragile economy while addressing the long term problem of over-spending,” says Marc Chandler, a strategist at Brown Brothers Harriman, a New York-based investment bank. “There was no long-term thinking here at all.”
That raises the risk of a sharp increase in US borrowing costs over coming years if investors balk at buying more Treasury bonds.
To make matters worse, Congress has shown an unwillingness to address the nation’s rising income inequality. Tax changes over the past decade have helped sharply increase the gap between rich and poor - boosting the average income of the top 0.1% by almost $400,000 a year and while the poorest received an annual lift of just $100, according to the Tax Policy Center.
The latest changes reverse only a fraction of this shift. Leaving aside whether or not this is fair, many academics believe extreme rates of inequality are economically damaging. Since the rich spend a smaller share of their income, a top heavy income distribution tends to mean lower demand for goods and services. It also encourages the less affluent to borrow more in order to keep pace, which can lead to financial instability.
The bottom line then is that the last minute deal in Congress avoids economic pain in the short term. Sadly, it also stores up problems for the future.
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