Wait for a last-minute fiscal cliff deal

However bumpy the road to avert the US fiscal cliff, market pressure will incite an agreement either just before the debt deadline or a week or two afterwards. There'll be no direct economic blow.

FT.com

Last Thursday saw the start of negotiations in Washington on a deficit-reduction agreement to be passed by year-end. If struck, a deal would avert the much-feared fiscal cliff – $500 billion in annual tax increases and spending cuts, which is set to begin in four weeks. Despite the immediacy of this threat, there is widespread fear that negotiations may fail, triggering this huge fiscal contraction and pushing the fragile US economy back into recession.

Fortunately this fear is misplaced because America will not go over the fiscal cliff and stay there. However bumpy the talks, a deficit agreement will probably emerge just before or a week or two after the year-end deadline. The agreement will reduce deficits without injuring economic growth. And it will boost consumer and business confidence.

Why this relative optimism? First, in the presidential election that just ended, taxes were debated every day. Not only did President Barack Obama win the election decisively but exit polls indicated 70 per cent support for his position on taxes, namely that high earners should pay more, but the middle class should not. In other words, the people have spoken on this issue and members of Congress cannot ignore that without jeopardising their own positions.

Second, capital markets will rebel against stalemate and recession risk. They are the most powerful force on earth, repeatedly forcing global outcomes that normal political processes cannot. The October 2008 congressional vote on the troubled asset relief programme legislation is particularly instructive. At that time, Lehman Brothers had collapsed, credit markets were frozen and fear reigned. The Bush administration proposed Tarp, and the Senate voted to establish it. But the House voted No. Stock prices immediately fell 800 points and, within 48 hours, the House reversed its position. Why? Because constituents were terrified.

Markets are already preoccupied by the fiscal cliff. If negotiations appear stuck, share prices will fall as year end approaches. Then, if the deadline passes without agreement, they will probably plummet. Under that pressure, as in 2008, Washington will probably produce a deficit agreement. At worst, Congress and the president would extend the middle income tax cuts on which they agree. There will be no direct blow to the economy.

Third, the US business community is now pushing for an agreement. Since election day, Obama has spent considerable, productive time with business leaders on this. Most of them will accept moderately higher tax rates, provided that spending cuts and the total savings package are big enough. This flexible approach from business weakens the anti-tax forces in Congress, who are the biggest obstacle to an agreement.

A successful agreement would embody three principles; it will be large enough to stabilise the debt to gross domestic product ratio, meaning about $4.5 trillion in savings over 10 years; it will include a balance of spending cuts and revenue raising measures; and it will be divided into two phases because, with just four weeks left, there isn’t time to legislate the entire package.

The negotiators already know the main elements of an agreement. Spending cuts should exceed the amount of new revenues. That should not be hard because $2 trillion of cuts are already agreed; $1.2 trillion in reduced discretionary spending was enacted last year and an additional $800 billion will be realised by ending the Iraq and Afghanistan deployments. But it is also time to restrain entitlement spending, which has been soaring. Steps such as means testing Medicare, modernising cost of living adjustment formulas and others could save another $600 billion. When the resultant interest savings are added in, total spending is reduced by $3.2 trillion over 10 years.

It is also important to include a growth initiative. The 2010 payroll tax cut and bonus depreciation should be extended together with emergency unemployment insurance and other expiring provisions. These would cost $200 billion annually, reducing the net spending cuts to $3 trillion.

That leaves at least $1.5 trillion of revenue increases to truly solve the debt problem. Two-thirds of that can be achieved by returning to the, slightly higher, Clinton-era tax rates on income and capital for high earners. Those rates coincided with an economic boom in the 1990s. Our income tax system is now less progressive than ever and a big majority favours such a move. Then, to reach the revenue target, the value of most tax deductions could be capped at about 20 per cent, removing the advantage high earners enjoy, where the value of deductions equals their higher rate of tax.

This overall package would fix the debt problem, support the economy and protect middle-income Americans while avoiding the fiscal cliff. It would also spur business investment and hiring and pave the way for eventual positive growth surprises. That’s why these negotiations must succeed.

The writer, who served as US deputy Treasury secretary from 1993-94, founded and chairs Evercore Partners.

Copyright The Financial Times 2012.

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