By Merlin Hernandez

The election is finally over and there is now the urgency to address what has been described as a looming fiscal cliff which can hurl the economy back into recession. On December 31, government spending cuts are due to kick in, while tax cuts and exemptions that boosted disposable incomes are set to expire. There is the expectation that the fallout would be a large contraction in spending that would strike a major blow to the fledgling recovery. The economy has been kept on life support through increased government spending, tax cuts, and maintaining an acceptable level of consumer spending through entitlements. Monetary policy nursed the ailing economy by carefully and creatively massaging growth with cash inflows and low interest rates over the last few years.

The election has essentially given the government the mandate to continue the policies that have painstakingly put the economy on the road to recovery. But this has come at no small price with ballooning debt and a huge budget deficit. And then there is the fact that the expenditure multiplier did not trickle down to create jobs due to outdated GDP measures, a tax structure that failed to treat effectively with outsourcing, and unwillingness in some quarters on to commit to the necessary tax reforms.

It is clear that government needs to continue to prop up the economy by maintaining spending levels, at least until the effects of QE3 is widely diffused and new investment stimulates required levels of job growth. But the deficit needs to be addressed as a matter of priority to avoid a catastrophic credit rating downgrade. A radical shift in the path to recovery is not an option as drastic spending cuts and a full roll back of tax breaks could reverse the current growth trend. The Obama government finds itself between a rock and a hard place. Compromise is indeed indicated but it will take bipartisan effort in a Republican controlled House.

On election night, President Obama tackled the issue head on by reaching out to the leaders of both parties to immediately begin a process to reduce the deficit, maintain tax cuts for the middle class, and provide tax incentives to small business in order to create jobs. The President remains in favor of tax increases on the wealthiest Americans. Republican House Speaker, John Boehner, has signaled an interest in some kind of interim fiscal arrangement that links reforms to both entitlements and the tax code and is known for his rigid position on no tax increases. The differences in perspectives take us right back to the 2010 impasse where tax reform became the victim of gridlock.

The urgency to create policies that will address the fiscal cliff means any interim arrangement needs to be very careful about reducing entitlements and increasing taxes on the middle class. This would cut the recovery off at the knees. The issue of entitlements should only be addressed when the business cycle is in expansion mode, beyond just the current trend – when employment is stabilized and spending approximates pre-recession levels

Avoidance of the fiscal cliff must be done in a way that sustains the recovery and may need to span both ends of the debate. This would involve maintaining entitlements, and making selective spending cuts in the short term. Tax code reforms will serve to bring jobs home, and provide incentives for job creation that will eventually relieve the burden of entitlements. But there is really no escaping some kind of tax increase and the need to enhance job creation may lead to limits to corporate taxation, leaving the wealthy as the most viable option. Once the recovery takes hold, massive spending cuts would need to be undertaken.

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