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Leader: The fiscal cliff has not been averted, just postponed

The deal struck by Obama and the Republicans leaves open the threat of dramatic spending cuts.

Since the global economic crisis began, the United States has avoided the path of austerity so hastily pursued by the UK and the eurozone. Subsequent events have vindicated its decision to do so. While Britain and the euro area have fallen back into recession, the US has experienced a sustained recovery. Its economy has grown for 13 consecutive quarters, with output now 2.2 per cent above its pre-recession peak, and unemployment has fallen to a four-year low of 7.7 per cent.

Failure to reach agreement on the “fiscal cliff”, the term coined by Federal Reserve chairman Ben Bernanke to describe the $607bn of tax rises and spending cuts which were due to take effect from 1 January, would have threatened almost all of this progress. The US Congressional Budget Office estimated that the total fiscal contraction of 4 per cent of GDP would cause the economy to shrink by 0.5 per cent this year and increase unemployment to 9.1 per cent. With its national debt now totalling $16.3trn (103 per cent of GDP), the US government needs a better balance between what it spends and what it earns, but such extreme austerity would be self-defeating.

It should have been possible for Barack Obama and Congress to reach agreement months ago on a deal that allowed for responsible deficit reduction while also protecting the economic recovery. That it was not was largely due to the intransigence of the Republicans, who grandstanded as fiscal conservatives while refusing to countenance tax rises on even the wealthiest Americans.

The deal eventually struck by Mr Obama and Senate Republicans in the final hours of 2012 was most notable for its limitations. Having won re-election on a pledge to raise income tax from 35 per cent to 39.6 per cent on those earning over $200,000 a year, while retaining the Bush-era tax cuts for other income groups, Mr Obama was forced to accept a significantly higher threshold of $400,000. At the same time, he agreed to the repeal of his administration’s reduction in payroll taxes (the US equivalent of National Insurance), meaning a higher tax bill for the low and middle income groups he aimed to protect. The return of the rate to 6.2 per cent from its current level of 4.2 per cent will cost a household earning the median income of $50,000 an extra $1,000 a year.

The wealthiest Americans, by contrast, retain most of the tax perks introduced by the Bush administration. Capital gains and dividends above $450,000 will now be taxed at 20 per cent, rather than 15 per cent, but this is still well below the 39.6 per cent rate seen during the Clinton administration, which ensured capital gains were treated in the same way as ordinary income. The top rate of inheritance tax will rise from 35 per cent to 40 per cent but the threshold remains an exceptional $5m, locking in favourable treatment for most of the country’s millionaires.

Both as a matter of social justice and economic policy, it is important for the richest, who are more likely to save, rather than spend, any tax giveaway, to bear the burden of austerity. But owing to the dogmatic stance of the Republicans, Mr Obama has sacrificed hundreds of billions in potential revenue. The danger remains that the US will seek to achieve debt reduction through dramatic spending cuts of $110bn, which the agreement reached this week simply postpones for two months. Once again, in a cynical game of chicken, the Republicans intend to use the forthcoming vote on raising the US debt ceiling (hitherto a formality under Republican and Democrat presidents alike) to extort large cuts to social security and Medicare. The fiscal cliff has not been averted; it has merely been postponed.

In his autumn statement last month, George Osborne rightly cited the uncertainty in the US as a threat to recovery of the British economy. Yet having pushed the UK off its own fiscal cliff in 2010, the Chancellor has little right to lecture political leaders across the Atlantic. Even with Britain in danger of an unprecedented triple-dip recession, there will be no let up in austerity this year. The decision to increase out-of-work and in-work benefits by just 1 per cent, below the rate of inflation, will further squeeze consumers’ spending power and reduce aggregate demand. In the case of the US, the hope remains that wiser minds will prevail and an unnecessary slide into recession will be prevented. But for the UK, the wrangling in Washington is an unhappy reminder that its fate was settled long ago.

This article first appeared in the 07 January 2013 issue of the New Statesman, 2013: the year the cuts finally bite

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Q&A: What are tax credits and how do they work?

All you need to know about the government's plan to cut tax credits.

What are tax credits?

Tax credits are payments made regularly by the state into bank accounts to support families with children, or those who are in low-paid jobs. There are two types of tax credit: the working tax credit and the child tax credit.

What are they for?

To redistribute income to those less able to get by, or to provide for their children, on what they earn.

Are they similar to tax relief?

No. They don’t have much to do with tax. They’re more of a welfare thing. You don’t need to be a taxpayer to receive tax credits. It’s just that, unlike other benefits, they are based on the tax year and paid via the tax office.

Who is eligible?

Anyone aged over 16 (for child tax credits) and over 25 (for working tax credits) who normally lives in the UK can apply for them, depending on their income, the hours they work, whether they have a disability, and whether they pay for childcare.

What are their circumstances?

The more you earn, the less you are likely to receive. Single claimants must work at least 16 hours a week. Let’s take a full-time worker: if you work at least 30 hours a week, you are generally eligible for working tax credits if you earn less than £13,253 a year (if you’re single and don’t have children), or less than £18,023 (jointly as part of a couple without children but working at least 30 hours a week).

And for families?

A family with children and an income below about £32,200 can claim child tax credit. It used to be that the more children you have, the more you are eligible to receive – but George Osborne in his most recent Budget has limited child tax credit to two children.

How much money do you receive?

Again, this depends on your circumstances. The basic payment for a single claimant, or a joint claim by a couple, of working tax credits is £1,940 for the tax year. You can then receive extra, depending on your circumstances. For example, single parents can receive up to an additional £2,010, on top of the basic £1,940 payment; people who work more than 30 hours a week can receive up to an extra £810; and disabled workers up to £2,970. The average award of tax credit is £6,340 per year. Child tax credit claimants get £545 per year as a flat payment, plus £2,780 per child.

How many people claim tax credits?

About 4.5m people – the vast majority of these people (around 4m) have children.

How much does it cost the taxpayer?

The estimation is that they will cost the government £30bn in April 2015/16. That’s around 14 per cent of the £220bn welfare budget, which the Tories have pledged to cut by £12bn.

Who introduced this system?

New Labour. Gordon Brown, when he was Chancellor, developed tax credits in his first term. The system as we know it was established in April 2003.

Why did they do this?

To lift working people out of poverty, and to remove the disincentives to work believed to have been inculcated by welfare. The tax credit system made it more attractive for people depending on benefits to work, and gave those in low-paid jobs a helping hand.

Did it work?

Yes. Tax credits’ biggest achievement was lifting a record number of children out of poverty since the war. The proportion of children living below the poverty line fell from 35 per cent in 1998/9 to 19 per cent in 2012/13.

So what’s the problem?

Well, it’s a bit of a weird system in that it lets companies pay wages that are too low to live on without the state supplementing them. Many also criticise tax credits for allowing the minimum wage – also brought in by New Labour – to stagnate (ie. not keep up with the rate of inflation). David Cameron has called the system of taxing low earners and then handing them some money back via tax credits a “ridiculous merry-go-round”.

Then it’s a good thing to scrap them?

It would be fine if all those low earners and families struggling to get by would be given support in place of tax credits – a living wage, for example.

And that’s why the Tories are introducing a living wage...

That’s what they call it. But it’s not. The Chancellor announced in his most recent Budget a new minimum wage of £7.20 an hour for over-25s, rising to £9 by 2020. He called this the “national living wage” – it’s not, because the current living wage (which is calculated by the Living Wage Foundation, and currently non-compulsory) is already £9.15 in London and £7.85 in the rest of the country.

Will people be better off?

No. Quite the reverse. The IFS has said this slightly higher national minimum wage will not compensate working families who will be subjected to tax credit cuts; it is arithmetically impossible. The IFS director, Paul Johnson, commented: “Unequivocally, tax credit recipients in work will be made worse off by the measures in the Budget on average.” It has been calculated that 3.2m low-paid workers will have their pay packets cut by an average of £1,350 a year.

Could the government change its policy to avoid this?

The Prime Minister and his frontbenchers have been pretty stubborn about pushing on with the plan. In spite of criticism from all angles – the IFS, campaigners, Labour, The Sun – Cameron has ruled out a review of the policy in the Autumn Statement, which is on 25 November. But there is an alternative. The chair of parliament’s Work & Pensions Select Committee and Labour MP Frank Field has proposed what he calls a “cost neutral” tweak to the tax credit cuts.

How would this alternative work?

Currently, if your income is less than £6,420, you will receive the maximum amount of tax credits. That threshold is called the gross income threshold. Field wants to introduce a second gross income threshold of £13,100 (what you earn if you work 35 hours a week on minimum wage). Those earning a salary between those two thresholds would have their tax credits reduced at a slower rate on whatever they earn above £6,420 up to £13,100. The percentage of what you earn above the basic threshold that is deducted from your tax credits is called the taper rate, and it is currently at 41 per cent. In contrast to this plan, the Tories want to halve the income threshold to £3,850 a year and increase the taper rate to 48 per cent once you hit that threshold, which basically means you lose more tax credits, faster, the more you earn.

When will the tax credit cuts come in?

They will be imposed from April next year, barring a u-turn.

Anoosh Chakelian is deputy web editor at the New Statesman.