The US economy is set to take a swam dive off the “fiscal cliff.”  What will be the damage?

The “fiscal cliff” refers to the implementation of the laws adopted in 2011 to raise the Federal debt limit in exchange for cutting expenses and reducing the Federal deficit.  The laws will end the “Bush tax cuts” and thus raise everyone’s taxes.  The laws will also expand the Alternate Minimum Tax regime that will also increase taxes for many.  Finally the temporary 2% reduction in Social Security contributions from employees will end.  The sum total of these tax hikes is estimated to increase federal revenues by up to 20% and thereby sharply reduce the deficit. 

The other major action will be to cut “discretionary” Federal expenditures, excluding entitlements, such as Social Security and Medicare, as well as Federal employee salaries and pensions (thank you God).  All other Federal expenditures will be cut by an average 10% including defense spending.   These cuts are projected to have less effect on reducing the deficit.

The genius of the laws adopted to reduce the Federal deficit is that they were born of “compromise” so cannot be blamed on one or the other of the political equation.  President Obama and the Congress agreed on this plan so both bear responsibility.  And the Congressional Budget Office (CBO), that master of “smoke and mirrors,” does say the laws will bring down the deficit and reduce the Federal debt. But the CBO also predicted that implementation of the new laws will cause a new recession.  So what will happen?

First of all higher taxes for all will definitely reduce expenditures and thus demand and thus economic growth and thus raise unemployment.  The real question is how much will higher taxes on capital gains and dividends stiffle even more, private investor interest in “stimulating” the economy and the private sector has already been roundly criticized for not joining the “good fight” to revive the economy.  My bet is that the stock market will also take a “swan dive.”

On the spending cut side the first battle will be over cuts to defense.  The Republicans in Congress have promised to pass laws to protect defense spending.  The curious political process here is that President Obama will have to join them in adopting such laws.  He needs defense spending to continue at present levels in order to conduct an “orderly” withdrawal from Afghanistan, his signature foreign policy success.  To cut military funds now could have truly disastrous results such as the US military having to fight it’s way out of Afganistan and maybe Pakistan to boot.  And adopting laws to protect defense spending will open the way for other laws to protect pet projects.

It looks like we are set for some more drama and heathbreak in our economy.   Plenty of new grist for my blogs.