The elections in the US are behind us now and it seems like the balance of powers in Washington has not materially changed. The Democrats maintain control over the Senate and the Presidency of course, while the Republicans dominate the House of Representatives. This split in control means that in order to resolve the Fiscal Cliff situation, an agreement between the two parties must be reached.
The main point of disagreement between the parties is about what to do with the tax reliefs that were put in place by the Bush administration almost a decade ago. For the US economy, the question is really about the effect of these changes rather than the identity of the ones affected by them. In other words, the political and economic questions are not identical.
The problem with a potential across-the-board tax hike is that it reduces disposable income. A lower disposable income means less saving and less consumption. The latter is a key component in the US GDP and any change in it can have grave consequences that will trickle to other sectors as well.
Taking a step back in order to explain the American personal taxation system is warranted here. Each year, every American files his taxes with the IRS. On one hand there is income and on the other hand there are tax-deductible expenses. On the net income, the person will pay a tax based on his/her tax bracket. Increasing tax revenue can come from either an increase to the marginal tax rate (figuratively – the tax rate applicable to the last dollar earned) or from eliminating or reducing eligible deductions.
And this is where Democrats and Republicans disagree. Each side cites both economic and ideological arguments supporting their positions.
Republicans are of the opinion that higher tax revenue should be achieved by lowering eligible tax deductions. That would result in a higher average tax rate but no change in the marginal tax rates. The economic sense behind this stance is that lower marginal taxes are associated with higher saving rates and more consumption. It is also important to note that Republicans are kind of anti-taxes in general. The free-market advocates opposed higher marginal tax rates on high-earning individuals; they view that as an unjust punishment inflicted on those who succeeded and did well in the open market and a deviation from Capitalism.
Democrats, on the other hand, are pro big-government and traditionally represent more lower-income earners and advocate more Socialist views (in American terms of course, nothing like a European Socialist). Their stance is that the first order of business should be to reinstate the marginal tax rate for high-income earning individuals back to pre-Bush levels as well as eliminate other tax breaks that this population is the main beneficiary of (for example, the Alternative Minimum Tax, taxes on dividends and capital gains). The economic logic here is that while the disposable income of the wealthy will be hurt more than that of lower income earners, the effect of that on the economy will be significantly smaller. The reasoning is that for the average American, a 1% tax hike translates to immediate effect on his purchasing decisions, while for the top 10% earners, that same percentage-point tax will have a smaller effect.
