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View from the fiscal cliff’s edge

After intense negotiations, the US Senate approved a legislation to avert, albeit temporarily, a potential $600 bn tax increase and spending cuts, Gaurav Choudhury reports.
Reuters | By Gaurav Choudhury
UPDATED ON JAN 02, 2013 01:06 AM IST

What is the fiscal cliff?

It is a budgetary crisis the US faced in end-December, arising from the end of old tax breaks, new taxes and spending cuts to control debt

What led to this state of affairs?

The US Budget Control Act (BCA) of 2011 imposed caps on the government’s discretionary spending aimed to slash spends by more than $1trillion over the next 10 years. It also set in a law the need for political agreement to reduce the government’s budget deficit by another $1.2 trillion over that period. It specified a “sequestration” procedure as a backup plan. In the eventuality that the political establishment failed to reach a deal by December 31, 2012, the sequestration - a form of automatic cuts that apply largely across the board - would have set in starting from January 1, 2013 involving rise in taxes, fall in government spending and a cut in unemployment benefits.

What was at the core of the debate?

The debate on how to prevent falling off the cliff largely centred on the structure of rollback of tax incentives. Budget deficits are function of both earnings and spending. Tax revenues constitute the largest component of a government’s earnings sheet. Likewise, subsidies such as unemployment benefits, account for a major chunk of government expenditure.

What were the main sticking points?

Raising revenues by rolling back of tax incentives to individuals and businesses that were given out to counter a slowdown a few years ago was where the Democrats and the Republicans differed. The Republicans had been arguing for extending the existing tax rates for all individuals, while the Democrats wanted a threshold income level beyond which it wants the taxes to be raised.

What’s happened on Tuesday?

After a marathon round of negotiations, US Senate overwhelmingly approved a legislation to avoid the so-called fiscal cliff in the wee hours of Tuesday, with 89 voting in favour and 8 against. The proposal households earning less than $450,000 a year have been spared an income tax rate increase. Also, it decided against slashing jobless benefits to the unemployed. . Payroll taxes-shorthand to taxes that are withheld from employees wages including some statutory deductions-would, however rise, to 6.2 % from 4.2 % last year.

What will happen now?

The Bill will have to be passed by House of Representatives, which will not scheduled to meet before Tuesday noon ( late Tuesday night India time). The proposals can be implemented only after the House of Representatives votes in favour of the Bill after which President Barack Obama will sign it into a law. Technically, it is possible for the House of Representatives to amended or reject any or all the proposals in the Bill, the final outcome of the deal is still not certain.

What does the deal mean for the US economy?

The deal, even if the House of Representatives passes it, would only mean that the US economy would have temporarily averted the potential $600 billion tax increases and spending cuts. The two-percentage rise in payroll taxes will likely reduce the take home wages for most. Besides, a higher income tax for the rich-to 39.6 %, from 35 %-- will bring down the net income of the wealthiest strata. Both these factors will reduce overall disposable income that can have a dampening effect on consumption spending. These, in turn, can slowdown the economy as people put off purchases and businesses defer capacity expansions.

What are the implications for India?

If the deal falls through in the House of Representatives, stock markets across the world may panic. India is no exception. Besides the US, which accounts for a quarter of the world economy, is one of India’s largest export markets. The deal, if it passes muster, will be a big positive for India’s exports, which have been shrinking for the last few months in wake of weak shipment orders from both the US and Europe. Stronger exports is also critical to spur the rupee that is still hovering around record lows.

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