US Politics Special: A 6-Point Guide to the "Fiscal Cliff"

President Obama calls on Friday for a resolution to avoid the "fiscal cliff"

See also US Audio Feature: So How Serious is This "Fiscal Cliff"? --- Scott Lucas with the BBC

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Editor's Note: As 2012 comes to a close, the emergency story in the US press is the "fiscal cliff". If there is no agreement by midnight, then tax cuts introduced by George W. Bush almost a decade ago will lapse, and funding of Federal programmes --- such as benefits for long-term unemployment and farm subsidies --- will be in jeopardy.

Discussions on Sunday were adjourned without agreement between the Obama Administration and Democratic and Republican leaders in Congress, despite Democratic concessions such as the raising of tax rates only on those making more than $450,000 a year and on an escalation of estate tax.

But as the haggling over details continues to the last minute, what are the basic economic issues? What happens if the clock strikes 12 and there is no dramatic resolution? EA's Lee Haddigan explains:

1. IT'S THE DEFICIT, STUPID

The central point is that both parties are searching for ways to reduce the Federal Government's annual budget deficit and its total debt. The US, with the world's largest economy, is in a more resilient position to avoid drastic austerity measures undertaken in Europe, but there is a pressing need to reduce the amount owed by the Government before the nation is forced to adopt draconian policies for fiscal stability.

Some economists, especially Paul Krugman of the New York Times, insist that the preoccupation with budgetary cuts is a phantom menace, and that the deficits and debt are not immediate concerns. They contend instead that, with a pro-growth programme, debt would be erased in the medium-term by an increase in revenues from a booming economy. They may be right, pointing to the stagnation in Europe caused by austerity policies, but they are off-stage right now in Washington's debate.

For Democrats, the best approach is to increase Government through increased taxation of the wealthy, with some targeted cuts in spending. For Republicans, the only way to reduce the deficit without harming the economy is drastic spending cuts, accompanied by some increase in revenue without raising taxes.

2. SO HOW DID THIS TAX ISSUE ARISE?

In 2001 and 2003, having inherited budget surpluses from the Clinton Administration, President Bush passed tax cuts. However, because of technical concerns with how these would be denominated in future budgets, the reductions were only passed on a temporary basis. They have been extended on previous occasions, with reluctance from Democrats, but they are due to expire in January.

The Democrats' position --- up to their concession last night --- was that the current rates should continue for those earning less than $250,000, but that they should expire for the 2% of Americans who earn more than that. Republicans counter that the increases would harm small-business owners.

Compromise on this issue appears straightforward. Republicans accept that taxes should rise on the wealthiest --- take your pick of at $400,000, $500,000, or at $1 million --- in return for Democrats agreeing to some cuts that they currently do not want in spending. However, Republicans have not voted for any increase in personal taxes since 1990, and more partisan members of the GOP caucus are not interested in any deal that threatens that record.

[Editor's Note: Last night the Republican leader in the Senate, Mitch McConnell, reportedly turned down the Democratic concession, by saying that the minimum level for tax increases --- effectively, a repeal of the Bush-era tax cuts --- should be $550,000.]

3. AND THESE CUTS IN SPENDING?

The second part of the cliff are the scheduled cuts in government spending --- the sequester --- agreed in a showdown over the debt ceiling last yeary

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The sequester provision was designed to be so tough that both sides would agree to a "Grand Bargain" to reduce America's debt over a 10-year period. No deal was reached, however, so those spending cuts are due to begin. They will reduce spending this year on Federal Government programmes by 8%, with defence spending slashed 9%.

Because of the failure of the Debt Commission last year to find a solution, Standard and Poor's downgraded America's credit rating. S&P argued that Washington's inability to establish permanent measures to reduce the deficit were causing a long-term problem, with politicians perpetually "kicking the can down the road".

4. THE PROBLEM OF THE "TEMPORARY"

So the fiscal cliff talks also need to deal with past temporary policies. Unemployment insurance for the long-term unemployed is set to expire, leaving millions with no cheques early in January. A payroll tax cut from 2010, seeking to boost demand in the economy, will also expire next month.

For years, Congress has passed a temporary "patch", the Alternative Minimum Tax, to prevent 150 millionaires from paying less tax than the average taxpayer. With the current deadlock, approximately 28 million Americans --- not just millionaires or the upper middle-class, but a married couple filing a joint income of $45,000 --- will pay the AMT from January.

A similar tale surrounds the Medicare "doctor's fix". In 1997, Congress attempted to restrain the growth in Medicare costs for physician services by linking them to the annual increase in America's Gross Domestic Product.

When doctors charged more in a year than the growth in GDP, they were supposed to cut the excess the following year. However, those decreases have been continually postponed by Congress through the "doctor's fix", and now the total amount which should be slashed is around 27%.

Then there is the obstacle around entitlement programmes like Medicare and Social Security. Republicans insist that any serious deal to reduce the deficit must include structural reform of those programmes. Most Democrats are vehemently opposed, mirroring the opposition of some Republicans to increased taxes.

Republicans floated the idea of restraining entitlement spending by linking annual increases to a "chained CPI" rather than the general inflation rate. That "chained CPI" assumes that, as prices rise on some products, people will buy cheaper alternatives. If adopted for Social Security, the principle would reduce payments by about 5%.

5. THEN THERE IS THE "DEBT LIMIT"

Even if the jump over the cliff is averted, Congress will have to strike a deal on raising America's debt limit. It officially reaches the ceiling of $16.4 trillion on December 31, but the Treasury through some accounting wizardry is meeting America's financial obligations in full for a further two months.

In return for an agreement to raise the debt limit, by say a trillion dollars for a year, Republicans are demanding an equivalent amount in spending cuts --- not just for one year but for a decade. Because the GOP will not agree to major cuts in defence spending, and because there is no room for sufficient cuts elsewhere in discretionary expenditure, reforms of entitlement programmes will have to be part of that discussion.

6. HOW SERIOUS IS THE FALL FROM THE FISCAL CLIFF?

The fiscal cliff was an unfortunate expression for what might happen in January. It portrays an immediate crisis bordering on calamity, when in fact most of the damage could be fixed by a deal early in January. As long as the markets remain calm until that deal is reached, then business as normal will continue for most Americans.

The continuing partisan brinkmanship in Washington is more of a concern for America's economic outlook in the long-term. Breaching the debt ceiling will cause a harder fall than any supposed leap over the fiscal cliff tonight. It is when those discussions near a climax that we are talking about the reality of a "shutdown" of essential prograammes. It is then that this situation becomes more than political theatre.