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Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money.
In January 2013, in the absence of political agreement, a series of automatic tax increases and spending cuts will be triggered. These were part of the 2011 legislative package which increased the debt ceiling allowing the government to continue to borrow.
Several temporary tax cuts will expire. The total amount involved is around US$500 billion through to September next year.
These include President George Bush's tax cuts on income, investments, married couples, families with children and inheritances, which were extended for two years by President Barack Obama. In addition, the alternative minimum tax would commence, affecting up to 26-30 million middle-class Americans, increasing their tax bill by an average of US$3,700.
The payroll tax cut of 2 per cent and extended unemployment benefits for the long term unemployed (both implemented by the Obama Administration to stimulate the economy) would also expire. A number of other smaller tax cuts for individuals and business (most notable tax credits for research and development and a deduction for state sales taxes) would also terminate.
Automatic spending cuts will also commence, totalling about US$600 billion per year and US$6.1 trillion over 10 years. The spending cuts would cover most government programs including cuts in defence spending and domestic programs. Medicare, the federal health programme for the elderly, would reduce payments including a sharp reduction (as much as 30 per cent) in reimbursements to doctors.
The automatic tax increases, non-renewal of tax cuts and spending cuts are equivalent to about 5 per cent of GDP. In a recent report, the non-partisan congressional budget office (CBO) estimated that the tax increases and spending cuts would reduce output by approximately 3 per cent and increase unemployment to 9.1 per cent by the end of 2012.
Bringing US public finances under control requires bringing budget deficits down, through spending cuts, tax increases or a mixture. The fiscal cliff is merely a step down that long road.
The task is Herculean. Government revenues would need to increase by 20-30 per cent or spending cut by a similar amount.
The US has a lower tax-to-GDP ratio (around 18 per cent) than even much maligned Greece (around 20 per cent). The tax-to-GDP in most developed countries is closer to 30 per cent.
Given 45 per cent of households do not pay tax (because they don't earn enough or through credits and deductions) and 3 per cent of taxpayers contribute around 52 per cent of total tax revenues, a major overhaul of the taxation system would be necessary. Tax reform, especially higher or new taxes, is politically difficult.
Large components of spending – defence, homeland security, social security, Medicare, Medicaid, (growing) interest payments- are difficult to control and also politically sensitive, making it difficult to reduce.
Reducing the budget deficit and debt may also mire the US economy in a prolonged recession.
In 2009 students at the National Defence University in Washington, 'war gamed' possible scenarios for bringing the US debt under control. Using a model of the economy, participants tried to get the federal debt down by increasing taxes and reducing spending.