2 January 2013 Last updated at 09:51 ET
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Global stock markets have rallied after a short-term deal to stave off the US “fiscal cliff” was reached.
The Dow Jones gained 1.8% at the open on Wall Street, while European shares were up by more than 2% for the day.
Failure to agree a deal would have triggered spending cuts and tax rises worth $ 600bn (£370bn), expected to throw the US back into recession.
However, the deal has only postponed by two months negotiations over spending cuts and the government debt ceiling.
Just before the New Year, the US Treasury Secretary Tim Geithner indicated that the federal government would run up against the debt ceiling – a legal cap on its total borrowing set by Congress – by the end of February.
The fiscal cliff deal does not include an increase in the debt ceiling. It also postpones by two months steep automatic spending cuts to federal government spending on things like defence and education.
The fiscal cliff measures – immediate tax rises worth $ 536bn, as well as spending cuts of $ 109bn from benefit payments and domestic and military programmes – were due to come into effect automatically at midnight on Monday.
Tax rises
The deal has averted most of these measures, including:
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This week’s deal lifts the risk of an accidental recession – at least for a while”
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- making permanent tax cuts dating back to George W Bush’s presidency, for individuals earning less than $ 400,000
- postponing the $ 65bn of automatic spending cuts for two months
- keeping benefits available for the long-term unemployed, worth $ 26bn, for another year
- postponing for another year an $ 11bn cut in Medicare payments
However, the deal did also allow some tax rises to go ahead, namely:
- the expiry of a payroll tax holiday, expected to raise $ 95bn in additional annual revenue
- allowing the Bush-era income tax cuts for individuals earning over $ 400,000 to come to an end, with the top rate increasing from 35% to 40%
- higher taxes on dividend income, capital gains and inheritance for these same top earners
- phasing out certain income tax deductions for individuals earning more than $ 200,000
The increase in payroll taxes is likely to be the most significant of these measures, in terms of how much it raises in revenue for the government, the number of taxpayers affected, and its impact on the economy.
Payroll tax is paid by all employees. The tax holiday – which cut the rate from 6.2% to 4.2% – was introduced by President Barack Obama three years ago to help stimulate the lethargic economy by putting more money in the pockets of ordinary American workers, who were most likely to go out and spend it.
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The battle [over spending cuts] has just been shoved two months down the road”
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Economists suggest that its expiry is likely to have the biggest impact on spending – particularly consumer spending – in the US.
Jan Hatzius, chief economist at Goldman Sachs, has said it would reduce US economy growth by 0.6%.
‘Disappointment’
The deal has postponed the hardest decisions that Republican and Democratic politicians must still reach agreement on – over spending cuts and the debt ceiling.
Both issues will need to be addressed at the end of February, with Republicans likely to demand deep cuts, particularly to entitlement programmes such as social security, in return for an increase in the legal cap on government borrowing.
President Obama’s Democrats would prefer to reduce the government’s deficit via further tax rises.
“In the most immediate sense, they took their feet of the cliff, but once again they have taken the hard work and pushed it down the street,” said Daniel Costello, a US economics commentator.
Fiscal cliff explained
- On 1 January 2013, tax increases and huge spending cuts were due to come into force – the so-called fiscal cliff
- The deadline was put in place in 2011 to force the president and Congress to agree ways to save money over the next 10 years
- The fear was that raising taxes while massively cutting spending would have huge impact on households and businesses
- Experts believed it could have pushed the US into recession, and had a global impact on growth
- A deal has been reached delaying some of the tax rises and all of the spending cuts by at least two months
“It’s a huge disappointment. The Republicans deeply wanted spending cuts. Their long-term goal is to finally start chipping away at some of the entitlement spending [on welfare payments] that is just getting out of control.”
Entitlement payments are expected to rise sharply in the coming decades as the post-World War II baby-boom generation retires and enters old age, entailing more government-funded medical care.
“Two-thirds of all federal spending comes from entitlement spending – that means when you wake up in the morning, two-thirds of the money is already spent. By 2020, that goes up to 90%.”
When President Obama last faced off against the largely Republican-controlled Congress over the debt ceiling in 2011, negotiations went to the wire before agreement was reached to increase the ceiling from $ 14.3tn to $ 14.7tn.
Markets fell sharply at the time on fears that, legally barred from borrowing any more, the government might be forced to default on some of its payment obligations, with unknown but potentially significant legal consequences.
The political wrangling also prompted ratings agency Standard and Poor’s to deprive the US of its top AAA credit rating.
Temporary lift
Despite the deal’s shortcomings, markets took cheer from the fact that agreement had been reached on how to postpone and moderate the process of bringing the government’s overspending back under control.
Richard Hunter, Hargreaves Lansdown: “This points the market in the right direction”
The FTSE 100 index rose 145 points to 6,043 points, the first time it has been above the 6,000 level in 17 months, with mining shares leading the way.
The UK market was also boosted by a survey of production and new orders in the manufacturing sector, which showed activity at a 15-month high in December.
Shares worldwide had been hurt in November and December by fears that the US would not be able to reach any kind of agreement and would go off the cliff.
Analysts said the relief would not last.
Mike McCudden, head of derivatives at stockbroker Interactive Investor said: “There will no doubt be a few more twists and turns in the days ahead… but for now, investors have the concrete news they were hoping for.”
Joe Rundle, head of trading at ETX Capital, said: “Today’s bullish tone may continue as we head toward the weekend. but the euphoria will most certainly evaporate, as the deal voted through does not include raising the debt ceiling and longer-term budget cuts.
“It’s only a matter of time before market participants lose their buzz as US lawmakers will have to reconvene to address the remainder of unresolved issues.”
BBC News – Business
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