America is now walking the fiscal plank

Markets are in a state of near-euphoria today –the main cause for celebration seemingly the fact that Congress isn’t quite as dysfunctional as everyone thought it was. Late on New Year’s Eve it averted the imposition of hundreds of billions of dollars of tax rises on all income classes.

The problem is that not raising taxes costs money – $4 trillion over the coming years according to the Congressional Budget Office. And although there are still a few tax increases that come into place this year, they raise less than half the amount the “fiscal cliff” revenue raisers were intended to.

Moreover, the tax side of things was always going to be easier to resolve than spending. And the need for the US to cut its spending is greater than ever. If you had any doubt about that perhaps this small nugget will help: by 2017, America will, for the first time in modern economic history, have a bigger government (in terms of public expenditure as a percentage of GDP) than the UK.

US vs UK government spending as a percentage of GDP. Source: IMF

The US already spends more on its health system than Britain – that’s state spending, before you’ve added on private health spending, which makes total US spending more than double Britain’s.

And these costs are set to soar even higher in the coming years for one simple reason. America, like Britain and much of Europe, has a welfare state which it cannot afford. Due to a combination of factors – some of them demographic, some of them associated with the cost of health provision – non-discretionary public spending is on the way up an ever-steepening slope.

Trying to arrest that increase, while retaining a system broadly regarded as equitable and fair, is the biggest challenge facing both this and future US administrations. Just as it’s the ongoing major dilemma in Europe and here in the UK. It is a challenge no other government has dealt with seamlessly.

Obama has only to look here in the UK for an example. The coalition government has committed to austerity, however, while it has been able to cut spending on big public investment projects (which is likely to have dented growth), it has been unable, so far, to cut spending on welfare. In fact, benefits spending has been one of the biggest increases in the Budget in the past year.

And that is the challenge facing the US as well – which is why Congress is debating strikingly similar measures as those imposed in the UK, including changing the inflation index used to calculate increases in benefits payments.

So in a way George Osborne really was right when he said “we’re all in it together” – this welfare affordability crisis is one the entire developed world is facing.

At some point, the US will have to cut spending, and it may well have to raise taxes again. The reality is that while the country has avoided toppling off the fiscal cliff, it is now walking the fiscal plank.