On or about the end of this year, some big things will be happening with federal government income and outlays. These are commonly referred to as "the fiscal cliff." Although these changes are complicated, I can simplify them a bit by leaving some small items out.
Basically, the substantial tax cuts George Bush put through on personal income, on dividends, on estates, on capital gains, will expire. That means taxes, especially for upper income persons and for those with large holdings of stocks, and with large estates, will go up quite dramatically. Some estimates put the total increase in the neighborhood of eight to nine percentage points for a high income earner.
The effect on stocks will be large, since the rate in dividends -- a large part of the return on stocks -- will more than double. That will make stocks less valuable by a goodly margin. Look out below.
The total intake from these tax increases is likely to be in the range of very roughly $250 billion (and I emphasize that this is a rough number) in 2013. There will also, slightly later, be the Obamacare tax hikes on high earners, which will add about 3.5 percentage points to the income tax rate for those with what the Obama regime dubs high income earners.
This abrupt drop off of the Bush tax cuts came because the legislative branch and Mr. Obama could not agree on a more nuanced and gradual way to raise taxes following the expiration of the Bush era tax cuts.
At the same moment, the federal government will begin what it calls "the sequester," in which very roughly another $300 billion will be lopped from federal spending. The slight majority will be from defense and the rest from "discretionary" federal spending, i.e., not interest on the debt or pensions.
The "sequester" came about because Congress and Mr. Obama could not agree on a plan to more selectively decrease federal spending than the meat axe approach. It troubles me very much because in this challenging world, I do not see the value of cutting defense spending. The principle at work here seems to be one that my father used to describe as, "We'll do something good for the country -- civilian cuts--as long as we can also do something bad for the country -- defense cuts." While China raises its war fighting spending rapidly, we will be hammering ours down. To me, this makes no sense.
In fact, in a nation where there are still so many out of work, I don't see the point of the civilian cuts right now, either.
But, here come a few points:
The point of the "fiscal cliff" and the sequester is to cut the deficit and attack the immense federal debt. But our spending and debt problems are so large that even with the tax hikes and the budget cuts, our deficit will still be roughly $500 billion in the next fiscal year -- one of the five largest deficits on record -- and our national debt will be racing towards $20 trillion.
That is how deep a hole we are in. The combination of Bush era tax cuts plus wars plus the stupendous deficits of the first Obama term have put us into a fiscal swamp. Even with these terrible cuts, we will still be marching towards default.
But it gets worse. There will be similar, perhaps larger cuts to spending in the next nine years. At the end of that time, there is some question as to whether we will be able to defend ourselves as a nation -- and our national debt will still be rocketing upwards as Obamacare kicks in.
How did this happen? The responsibility, in my mind, largely rests with a well meaning but mistaken idea: that drastic cuts in income taxes would raise economic activity so much that we would collect more federal revenue. There never was any data proving this. There never was meaningful theory proving this -- i.e., that large tax cuts would raise productivity and labor force participation dramatically. In fact, the data showed otherwise. Nevertheless, the tax cuts went through under Bush 43, and spending exploded under Obama, and now we are in for it.
The chickens have come home to roost, as the old saying goes.
To coin another old saying, taxes, especially for the high income earners here in California, where I live, are going "sky high." Instead of a roughly 35% top federal rate, we will have a roughly 43% top federal rate. At the state level, with Jerry Brown's new taxes in effect retroactively, we will have a top state income tax rate of roughly 15%. Then, we get the Obamacare hike and we are -- whaam -- over 50% and more on the way, because we will still be running big deficits.
I hate to say this, because many of the Bush tax cutters are pals and colleagues, but those Bush 43 tax cuts, well intentioned by well intentioned men and women, have just thrown us into a deep and damp ditch, and Obama's spending has compounded the felony-- and getting out will be a struggle.
This doesn't even address the effect all of this federal de-stimulus (I made up that phrase!) will have on the macro economy. Will it push us back into recession? We don't know. We have a very large economy and we do not really know if raising taxes hurts or helps. When the Congressional Budget Office says the "fiscal cliff" will cut some amount they calculate to one tenth of a percentage point off the growth of the economy, they are making a calculation that simply cannot be made. It is just child's play. The effects of economic events are extremely difficult to measure, and their magnitudes are impossible to measure in advance or even in retrospect. There are, as Hayek said, just too many different factors operating at once to say which factor had which effect and how much it was.
In the meantime, there is a lesson here for policy makers: do not embark upon large fiscal policy ventures without having some idea of the effects. This goes for tax rises, tax cuts, and above all, for defense cuts. It would be sad if the "fiscal cliff" pushed us into recession. It would be a catastrophe if it led to war for which we were ill prepared.