AMERICA, it appears, will go over the fiscal cliff after all, but only for a few days. If all goes as planned, the worst of the cliff, a withering combination of tax increases and spending cuts, will be avoided, while the ugly fiscal arithmetic and political dysfunction that produced the cliff in the first place will remain.
A deal nearing completion in the Senate would make permanent the tax cuts first enacted by George Bush in 2001 and 2003 and due to expire on December 31st, except for the wealthy. The marginal rate for individuals earning more than $400,000 and couples earning more than $450,000 would rise from 35% to its pre-2001 rate of 39.6%, while deductions would be curbed for some people earning as little as $250,000. Estate taxes would go up, but not to pre-2001 levels, while rates on capital gains and dividends, now 15%, would go up to 20%, still less than their pre-2001 levels. Tax credits for families, workers and college students first introduced in Mr Obama’s stimulus plan will be extended for five more years.
Although passage in the Senate seemed certain, the bill's fate in the House is more of a wild card. Partisans on both sides hate the deal: liberal Democrats because it does not raise rates on everyone earning more than $250,000, as Mr Obama had long demanded; Republicans, because they are being asked to approve the first increase in tax rates in two decades while getting no spending cuts in return. (Update: the senate approved the agreement early Tuesday by a vote of 89 to 8. The house approved it late Tuesday 257 to 167, with 85 Republicans joining nearly all the Democrats.)
Nonetheless, both sides realised the alternative would be much worse. If the country entered January with no deal in sight, taxes would rise on the vast majority of households, a hit worth more than $300 billion, or 2% of GDP, per year. Since the House will not vote until January 1st at the earliest, taxes will rise, at least for a day. But most households will not notice because employers should be able to withhold taxes at the same level as last year by the time the first paychecks of January go out.
By avoiding that hit and finally nailing down numerous features of the tax code, the deal lifts a cloud that had hung over the economy and investor confidence. But on almost every other point, the deal falls short of already low expectations. It leaves in place significant short-term austerity while doing nothing to change the long-term trajectory of debt. It doesn't reform taxes or entitlements. And it doesn't deal with several key components of the cliff.
The main elements of the fiscal cliff were the expiring Bush tax cuts; expiring extended unemployment insurance benefits; an expiring payroll tax cut; automatic spending cuts worth $110 billion per year, spread equally across defence and domestic programmes (called a sequester); and the debt ceiling, the statutory limit on how much the Treasury must borrow, which was reached on Monday.
The current deal covers only the Bush tax cuts and enhanced unemployment-insurance benefits, which will continue for one more year. The payroll-tax cut will expire as scheduled, sapping workers’ purchasing power by roughly $1,000 each. Together with the higher taxes on the rich, that will impose a significant fiscal drag on the still-fragile recovery early in 2013.
The sequester was due to take effect this week. That will be delayed for a few months. The White House has discretion to backload some of the cuts for now, in hopes of a negotiated delay or replacement. But the Pentagon has already warned some of its 800,000 civilian employees of furloughs, and contractors who do business with the federal government may start to lay workers off.
Meanwhile, the Treasury can use various accounting manoeuvres for about two more months before it completely runs out of room to borrow without an increase in the debt ceiling. At that point, it will have to stop paying some bills—to Social Security (pension) beneficiaries, soldiers, Medicare doctors, and perhaps eventually bondholders, bringing on default.
Permanently replacing the sequester and raising the debt ceiling will require intensive new negotiations likely to begin as soon as the tax deal is signed into law. Yet the last few months have shown the two key players to be incapable of making those sorts of deals. It is telling that both Mr Obama and Mr Boehner were on the sidelines as the final deal was worked out between Mitch McConnell, the Republican minority leader in the senate, and Joe Biden, who in addition to being vice-president is a former senator.
Eight weeks ago, hopes ran high inside and outside Washington that Mr Obama and Mr Boehner could in fact strike a grand bargain: higher revenue in return for entitlement reform. Mr Boehner hoped to revive the deal he briefly entertained with Mr Obama in the summer of 2011 along just those lines. But Mr Obama, his hand strengthened both by re-election and the economy’s stronger footing, was less inclined to compromise, and focused instead on forcing Republicans to accept much higher taxes on the rich or pay a grievous political price for refusing. “It’s not acceptable to me, and I don’t think it’s acceptable to you, for just a handful of Republicans in Congress to hold middle-class tax cuts hostage simply because they don’t want tax rates on upper-income folks to go up,” he declared at a campaign-style event in late November, while his and Mr Boehner’s staff were trying to narrow their differences.
For his part, Mr Boehner never seemed sure of what his own members could accept, which made for unproductive negotiating sessions. He offered $800 billion in new tax revenue without apparently saying how the money would be raised. Democrats were willing to consider curbs on entitlements, as long as Republicans bore responsibility for putting them on the table. Mr Boehner seemed unwilling to accept that burden, instead haranguing Mr Obama for failing to specify his own entitlement cuts. Nor was it clear what Mr Boehner could deliver on taxes; his own bill to raise taxes on just millionaires had to be yanked because of insufficient Republican support. Rather than a sign of negotiating strength, it became a humiliating sign of his ineffectiveness.
Since the summer of 2011 Republicans have insisted on deep cuts to spending as the price of raising the ceiling, even if it means risking default. Some will be doubly determined to pursue that strategy now. They rightly complain that the deal does nothing to alter the long-term upward trajectory of the debt. Higher taxes on the rich will reportedly raise about $600 billion over a decade, an “inconsequential” sum, noted Bob Corker, a Republican senator. Indeed, it is almost a rounding error against a ten-year projected deficit of $10 trillion on current policies, or 5% of GDP. “The fact that the president won’t challenge his party on spending cuts is disgusting,” said Steven LaTourette, a Republican congressman.
While Republicans will try to use the sequester and debt-ceiling negotiations to secure the spending cuts that this week’s agreement omitted, Mr Obama signaled today he was equally determined that taxes have to rise further, too. “If Republicans think that I will finish the job of deficit reduction through spending cuts alone…they’ve got another thing coming,” he said in a brief public appearance Monday that riled Republicans with its partisan, combative tone. It may be that Mr Obama was mostly trying to reassure his own liberal base that it was the opposition, not him, who caved in this time. But it may also be a sign of the tone likely to prevail in coming months.
