Hike taxes or cut government spending, choices faced by American voter
Hopefully cooler heads prevai
There’s no easy solution to America’s fiscal situation, but confronting it doesn’t need to result in throwing the U.S. economy (and Canada’s along with it) over a cliff either.
Economic news coming out of the U.S. has been slightly sunnier, providing a glimmer of hope that the U.S. economy is on the mend. But there are some clouds in the forecast in the form of the American sovereign debt situation.
What America does after the election to balance its books is going to have significant consequences for the world’s medium term economic outlook.
What all governments want when they’re in a fiscal mess is to be able to grow out of it, as it avoids politically unpopular decisions. The American recovery will certainly help on this front, but it simply won’t be enough to fix the fiscal mess they’re in. A decision will have to be made with respect to both how quickly the imbalance needs to be addressed, and what needs to be done to get there.
The clock is ticking
If nothing is done, then the budget deficit is scheduled to close quickly – too quickly. In the months following November’s election, the Bush-era tax cuts scheduled to end, major spending cuts are scheduled to take place due to the failure of last year’s super committee to find an agreement and the pay-roll tax cut exemption will expire. According to the Congressional Budget Office (CBO), the budget deficit would drop to 2.1 per cent by 2014 (from north of 6 per cent today).
The fear is that by allowing the scheduled cuts to take place the economic recovery will be hampered or, at the very least, slowed significantly. In fact, economists at the Bank of Canada estimate in the Monetary Policy Report, that the spending cuts and tax increases may shave as much as 2.5 per cent from U.S. GDP growth. Needless to say, this puts a real economic cloud over the immediate horizon.
Of course, just because these amendments to the tax code are scheduled to take place doesn’t mean they actually will. They are ultimately political decisions and it’s not inconceivable that legislators will still make amendments to the legislation before they come into effect to shield the still nascent recovery. That said, the clock is ticking and while it may be possible to put off the inevitable pain for a year or tw, it can’t be done indefinitely.
When the decision is finally made to place the U.S. government on a sustainable path, there is considerable debate as to what the best path is. Should increasing revenues be the primary focus or should limiting government expenditures dominate? To a large extent this is the question the American electorate will be answering in November.
The focus on the left has been an eventual return of taxes to where they stood back in the ‘90s under President Bill Clinton. This would mean an increase in the tax burden placed on upper income individuals (they were also the ones who disproportionately benefited from the cuts).
Households would have to respond by either lowering spending or altering their saving and therefore investment behaviour. As high income individuals tend to not consume most of their income to begin with, it’s likely the latter would dominate.
Should we fret about a possible reduction in investments? Under the gold standard it would certainly be a huge problem, as it would, by definition, limit investment spending. But we don’t live in this world. In the world we live in, firms are free to tap funds from just about anywhere in the world and the amount of money sloshing around, thanks to central banks printing it, is dangerously high.
Short-term pain for long-term gain
The alternative, to directly curtail government expenditures, is supported by the notion that short term pain may result in longer term gain. There would be some reduction in economic growth, as government spending retrenched, but down the road the economy would improve as the economy becomes more efficient. At least that’s the theory.
There’s no easy solution to America’s fiscal situation, but confronting it doesn’t need to result in throwing the U.S. economy (and Canada’s along with it) over a cliff either. Hopefully cooler heads prevail.
Will Van’t Veld is an economist with ATB Financial.
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