Don’t Expect Big Budget Cuts

A lot of analysts looked at the results of the widely covered “fiscal cliff” negotiations and decided that each side got half a loaf. On the one hand, Democrats secured, in effect, tax increases for very high income Americans that will raise some $600 billion over 10 years. They also won extensions for unemployment payments. On the other hand, Republicans gave up less in tax increases – their biggest single issue — than most observers expected. Federal income and capital gains tax rates of various kinds went up only for individuals with incomes above $400,000 and couples with incomes of more than $450,000. (Congress also made permanent the lower tax rates of the last 10 years that affect most income levels, but which were to expire January 1.)

Both sides now say they want to turn their attention to cutting the budget significantly; haggling over that will likely continue into February or March, with a debt ceiling deadline the next crunch point. It remains an open question whether an impasse will lead to a federal cash flow emergency in which the U.S. can’t pay its bills and sees a reduction in the rating of its debt. In 2011, the United States was only days away from defaulting on various payments, and as a result suffered its first-ever credit-rating reduction.

But for Kent Smetters, Wharton professor of business economics and public policy, that also is a moot question. In his view, the GOP gave up “all of its leverage” by agreeing to tax increases without making budget cuts part of the deal. As a result, he says, “I think that serious cuts are now unlikely…. The common myth is that serious budget cuts can happen after the economy recovers. But, without serious budget cuts, the necessary investments won’t be made if innovators and investors think that their hard work and risk taking will eventually be taxed away. Even if cuts are phased in, a plan is needed right now.”

Smetters is also a former deputy assistant Treasury secretary and economist for the Congressional Budget Office.

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