The US Fiscal Cliff

I am entertained currently by the news from our American cousins about the forthcoming "fiscal cliff" which takes about $600bn a year out of the US economy and therefore is viewed as the end as we know it. Amid all the posturing, with the Democrats wanting to massively increase taxes and keep spending while the Republicans want to freeze taxes and slash spending, it's worth taking a look at what the fiscal cliff entails and whether the parties will let it happen.

The spending cuts portion of the cliff is actually (relatively) tiny - $110bn, of which half comes from defence and half from non-defence. Since the 2012 US federal budget had $3.8tn of expenditures this is a little less than 3% of cuts. I do not therefore feel that this is going to be the end of the world. The main Republican objection is that the military cuts will be disproportionate: $55bn out of $688bn is about 8% of cuts. Having said that, I suspect that the Democrats are going to be able to make most of that stick.

The cliff is heavily weighted towards tax increases, which is why I suspect the Democrats won't feel overly pressured to stop it. There are a lot of different areas affected. If you look at the 47% of citizens who don't pay federal tax (income or capital gains), it looks like they'll mostly feel the additional 2% Social Security (on up to $110K of income), the loss of earned income tax credit for some of them, and (depending on income) the increased scope of the Alternative Minimum Tax. If you have a single-earner household getting $40K, with 2 kids, filing jointly, I reckon you could easily be looking at an extra thousand or so in additional tax. Richer taxpayers will be more heavily hit: for $100K earners, the additional 2% Social security raises $2000 by itself, plus a 3%-5% raise in most income tax bands and reduction in some tax credits, means you could be looking at a $4000K+ additional tax bill. The overall impact of the tax section of the fiscal cliff is $500bn, which given 180 million workers is around $2700 per worker of impact. (Actually it's not quite that bad since the capital gains rises will bring quite a lot of money from the invested moderately well off elderly, and the estate tax rise is substantial as well - still, looks like $2000 per worker is the right ballpark.)

Because so many earners will be hit by these tax increases, I suspect the Democrats will need to push to change the balance of where they hit; it is no coincidence that the "tax the rich" mantra has been increasingly strident this year. Unfortunately, as many people note, there just aren't enough of the "rich". If you tax the top 1.8% of workers (1 million people) an additional $20K each, you're still only getting $20bn out of the $500bn you actually need. Even if you tax them $100K each, that's still only 20% of what you need. If you don't want to tax the poor, most of the taxes are going to have to come from the middle class - there aren't enough rich people to make a difference.

I suspect that mortgage interest tax relief is going to be on the table as a moderately bipartisan measure. It loses about $100bn of tax take annually, and even rich homeowners can benefit substantially:

As The Huffington Post previously reported, Barack and Michelle Obama claimed a $47,564 home mortgage interest deduction on their house in Chicago, which they bought in 2005 for $1.65 million. That equates to a savings of about $13,000 on their federal tax bill.

The Democrats will like it as an attack on "the rich", and the Republicans may well not mind it because many of the very expensive houses tend to be in solidly Democratic states like New York and California. I would guess that they'll drop the upper limit for house value from $1mm to around $300K, maybe staging the drops over a few years, and keep the option open to remove it completely.

I don't see the Democrats and Republicans coming to a credible agreement before January, however. I suspect there will be some more kicking the can down the road, maybe some token tax rises on the rich, but the USA will still end up spending far more than it raises in 2013. Let's not forget that the 2012 federal deficit was $1.3tn - even the fiscal cliff would only raise half of that gap.