The Fiscal Cliff

Introduction

Fiscal cliff is a term commonly used in the United States, which refers to measures put in place by the federal government to simultaneously cut down government expenditure and increase tax rates as from January 2013 (Hinch). Fiscal cliff describes the challenge that the American government encountered at the end of 2012 when it scheduled to implement the Budget Control Act of 2011 (Hollander). The budgetary deficit that he US government has been facing is expected to reduce by half in 2013. In December 2012, the Congressional Budget Office estimated that the policies in fiscal cliff will likely lead to a slight recession accompanied with higher unemployment rates in 2013. This will be followed making the labor market more strong, which might enable more economic growth. 

In effect to this, the American Taxpayer Relief Act (ATRA) of 2012, to a great extent, did away with the revenue suggested in the fiscal cliff through implementing a smaller increase and a higher deficit compared to other laws enacted in previous years.  In addition, more regulations that will ensure adjustment on spending were expected to be implemented in the start of 2013 (Hinch). Other changes that were supposed to take place at midnight on 31/12/2012 due to fiscal cliff include a cut in temporal payroll tax that is expected to result to 2% increase in tax for workers. Additionally, a cut on spending was expected, which was agreed upon by the 2011 debt ceiling deal. This adjustment has provoked public debate as well as media coverage during the end of 2012. It was projected that the previously enacted legislations that gave birth to fiscal cliff will result to 19.63% rise in revenue as well as 0.25% fall in government spending from 2012-2013. Some of the legislations that were enacted include the planned spending cuts as implemented by the Budget Control Act of 2011 and the expiry of 2010 Tax Relief Act. The Tax Relief Act elongated the Bush Tax Cut for roughly 2 years while the 2011 Control Act was enacted to give a sustainable solution to the dispute that concerned the public debt ceiling as well as addressing the letdown by the 11^th Congress, which failed to pass the federal budget. The fiscal cliff policies highlight issues such as Medicaid, Social Security, federal pay, and veterans’ pay, which would have been excluded from the spending cuts. Through this approach the federal government discretionary spending is expected to be reduced through broad cuts called budget sequestration (Hollander).

ATRA eliminated a big fraction of the tax side fiscal cliff while the reduction in spending because of budget sequestration, which was delayed for roughly 2 months. Due to the implementation of this act, Congressional Budget Office (CBO) projected 1.15% increase in expenditure and 8.13% increase in revenue for fiscal year 2013. This act led to a projected $157 billion fall in the 2013 budget deficit instead of the projected reduction of $487 as suggested under fiscal cliff. The increase in revenue was a result of raised marginal income as well as capital gains relative to the ones used in 2012 (Hinch). Additionally, certain tax deductions and credits for individuals with more than $250000 were phased out. The expiration of the payroll tax cuts also contributed to this.

Legislations that Led to the Fiscal Cliff

The term fiscal cliff is not a new term in the US. The term has been used since 2011 but was widely used since 2011 to refer to federal budget deficits. There are several legislation that were enacted by the congress to ensure that fiscal cliff takes shape (Hollander). In December 2010 when the lame-duck session was in operation, the Congress enacted the Tax Relief Act, Job Creation Act, and the Unemployment Insurance Reauthorization Act. These acts elongated the Bush tax cuts for two more years and implemented the exemptions required by the Alternative Minimum Tax for fiscal year 2011. In addition, the acts authorized a reduction in the Social Security Tax for one year, which was extended to 2013 by another act called the Middle Class Tax Relief and Job Creation Act (MCTRJCA) enacted in 2012. MCTRJCA supported the federal unemployment benefits and the reduction of Medicare payments to physicians.    In 2 August 2011, the Congress enacted the Budget Control Act (BCA) as part of the resolutions made to handle the debit-ceiling crisis. This act formed the Joint Select Committee on Deficit Reduction (JSCDR), which provided legislations by November 2011 that reduced the deficit by approximately $1.2 trillion. When JSCDR failed to meet its obligations, BCA came up with another committee that was given responsibility to direct across-the-board cuts (Hinch). This committee carried its responsibility successfully and succeeded in evenly splitting between domestic spending and defense in 2 January 2013. In addition, the Affordable Care Act came up with new taxes on households that made more than $250000 per annum.

In December 2011, the alternative minimum tax (AMT) exemption expired. This AMT expiry made the government to revert to the 2000 tax rates, which translated to a 26% drop in tax dues for single individuals and 40% for married couples. However, the fiscal cliff did not take shape as intended by the federal government. It was eliminated in midnight December 2012 at the last minute of legislating policies that could implement it. On 1 January 2013 at 2 a.m. the congress enacted the American Taxpayer Relief Act. this 2012 bill was passed without any amendments at  1 a.m. the same day. However, the sequestration policy (spending cuts) had many impacts to the American people (Hollander). Firstly, the American federal budget deficit expressed as a percentage of the GDP continued for some time. The baseline deficit showed the actual effect of fiscal cliff implying that tax cut expiry applied. However, the elements in spending reduction have been reflected in the 2011 Budget Control Act that directed the reduction in defense discretionary spending (Hinch). The scope of this act excluded many major mandatory agendas e.g. Medicare and the Social Security. In January 2013, the Congress failed to reach  a consensus on spending cuts and thus leading to the delay in sequestration until March 2013. 

Keynesian and New Classical Theories Perception of Fiscal Cliff

Keynesian model has developed a theory that has explained the relationship between consumption, savings, investment, and production in an economy. In the Keynesian theory, the intersection between aggregate demand and aggregate supply dictates the equilibrium level of employment in a country. This theory focused its analysis in the short-run where prices not flexible, there is effective demand, savings and investment by the household fully depends o the disposable income, and the desire to save depends on future capital investment. Proponents of Keynesian model believe that macroeconomics is far much beyond aggregate market. Individual resource and commodity market cannot achieve equilibrium and the possibility that the economy will stay in disequilibrium for a long time is high (Sanandaji). In addition, Keynesian model believes that full employment is not guaranteed in a realistic economy. Therefore, Keynesian model can be used to solve American federal budgetary deficit. For instance, the American government can use the intersection between aggregate demand and aggregate supply to determine factors such as tax rates, interest rates, equilibrium output, and many more economic issues. Therefore, proponents of Keynesian model will advise the American government to use the intersection between demand and supply to determine tax rates and levels of government spending (Blinder).  

On the other hand, new classical theory was built on the assumption that a free market is in position to regulate itself if it is left alone from external interference such as government interference and human intervention. Unlike Keynesian model, classical theory describes an economy in the long-run and is working in full employment. It assumes that there is no excess capacity as well as absence of classical unemployment (Nicolai, 307). Therefore, if the employment is moving at full employment level firms have no opportunity of increasing production in case demand increases since all capacity has been employed. Instead of an increase in production due to increased demand, price of commodities increase and thus the model assumes that the supply curve is always vertical. In reference to the fiscal cliff, proponents of classical model can fail to give reasonable explanation. This is because classical model assumes that the economy is operating at a full level of employment. In practice, there is no economy that can realize full employment. Additionally, classical theory applies to free markets, which do not have government or any human intervention. On the contrary, the American market faces a lot of government interventions. For instance, the government makes decisions pertaining the tax rates as well as money in supply (Eltis, 13).

In conclusion, fiscal cliff refers to measures used by the US government to simultaneously reduce government spending and increase tax rates. Fiscal cliff was intended to put a check on budgetary deficits that the US federal government has been facing. There are several legislations that were enacted from 2010 to 2012, which were to ensure that fiscal cliff becomes very effective. Some of these laws have helped the government to reduce the deficits. The congress expects that if fiscal cliff is fully implemented USA’s budget predicament will be solved.