Fiscal Cliff & its Impact on India

By,

Abijith Kavi, Shrishail M & Suresh A M

What’s the Fiscal Cliff?

“Fiscal cliff” is a phrase coined by Federal Reserve Chairman Ben Bernanke.

A situation in which sudden changes in government expenditure and taxation have a profound effect on a country's economy.

This refers to the simultaneous expiry of tax breaks and the introduction of tax increases and spending cuts that were due at the end of 2012, the cumulation of which were expected to push the US back into recession.

If Congress and President Obama do not act to avert this perfect storm of legislative changes, America will, in the media's terms, "fall over the cliff." Among other things, it will mean a tax increase the size of which has not been seen by Americans in 60 years.

What Caused Fiscal Cliff

• Often, economic crises are caused by real physical problems – like draught, war, demography or technological innovation that robs one economy of a competitive advantage over another.

• Other times, economic crises result when asset bubbles burst, or financial markets collapse. The Great Depression - and The Great Recession.

• The economic crisis of the moment - the "fiscal cliff" - does not result from any of these factors. In fact it is not a real "economic crisis" at all, except that it could inflict serious economic hardship on many Americans and could drive the economy back into recession.

So what actually caused the cliff?

A number of laws led to the fiscal cliff, including these provisions

• Expiration of the Bush tax cuts enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003, as extended by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010;

• Across-the-board spending cuts to most discretionary programs as directed by the Budget Control Act of 2011;

• Reversion of the Alternative Minimum Tax thresholds to their 2000 tax year levels;

• Expiration of measures delaying the Medicare Sustainable Growth Rate from going into effect as extended by the Middle Class Tax Relief and Job Creation Act of 2012.

Continued

• Expiration of the 2% Social Security payroll tax cut, most recently extended by MCTRJCA;

• Expiration of federal unemployment benefits, as extended by MCTRJCA.

• New taxes imposed by the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010

These provisions were to automatically go into effect on January 1, 2013 without new legislation Some provisions increased taxes while others reduced spending

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CBO projections of the sources of deficit reduction in the FY2013 budget.

Effect on Domestic Economy

Tax- A large number of Federal tax provisions will expire, raising taxes across the board. Tax rates on income, capital gains and dividends, estates and payrolls will all rise and other tax provisions such as the child care credit are set to be cut back or eliminated.

Real GDP- Increasing the current income, capital gains and dividend tax rates shows noticeable negative effects on the U.S. economy and does hurt compared to the Baseline.

Consumption Spending- The greatest damage is to consumption spending, losses average over 1 trillion per year over the 2013-2021. Between 2013 and 2017, consumption also falls by an average of $1 trillion as well.

Capital Spending- Spending for business investment declines when tax rates on income, capital gains and dividends revert back to pre-Bush levels; on average $48.5 billion yearly between 2013 and 2021.

Savings- A substantial decrease in the funds available for savings occurs and a decrease in the “flow-of-funds” savings rate, derived from Federal Reserve flow-of-funds data.

Federal Government Budget Receipts- Higher taxes on capital gains and dividends significantly harm the economy and job growth and suggest that the increase in federal tax receipts may not be a worthwhile tradeoff.

Continued

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Effect on Indian Economy

If American consumers have less money = they buy less= not good for Indian exporters (especially polished diamonds).

Many American companies outsource their research and development work to India, particularly pharmaceuticals (clinical trials of drugs), software, engineering. If Obama removes the tax-benefits given to them (+consumer demand already down)= they'll either delay payments, cancel or renegotiate the contracts given to the Indian companies.

If American Corporate have to pay huge taxes @ home, and consumer demand is already low, they'll try to concentrate more on India and other emerging economies to get new customers (Retail, Aviation, Pension-insurance) = More FDI may come to India.

Americans already burned their hands in share-market and real-estate, if this fiscal cliff leads to recession, they'll park their money in GOLD = demand of gold increased= gold becomes even more expensive = bigger Current Account deficit for India (because we too love gold) = Rupee weakens against dollar, because when we import gold, we've to pay in dollars= we've to pay more rupees to buy same amount of crude oil = petrol price increase = inflation.

Continued

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