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“Fiscal cliff” averted, but debt ceiling battle looms

Jennifer Kwan

The last-minute deal to avert the so-called "fiscal cliff" of steep tax hikes and spending cuts was one small reason for investors to rejoice, but by most accounts a bigger, scarier battle ensues over spending cuts and Washington's debt ceiling.

The Republican-led House of Representatives backed the deal earlier this week after a bitter and wildly entertaining political struggle. It was seen as a big win for President Barack Obama, who had vowed on the hustings to address budget problems, in part, by hiking taxes on America's wealthiest.

"As it turns out, Washington isn't so dysfunctional that it would drive the U.S. economy into recession by piling on aggressive tax hikes and spending cuts in a single year," said Avery Shenfeld, chief economist at CIBC World Markets.

But he added the ensuing market rally was more about removing the risk that "American politicians really were that stupid, and would fail to reach a deal."

The agreement focused on reducing some of the tax hikes that were due to take effect Jan. 1, but pushed back by two months some $110 billion in spending cut decisions.

After digesting the news, many agreed the deal was largely a Band-Aid. And experts warn of more intense political wrangling between the Democrats and Republicans, with the latter reportedly bitter the fiscal cliff deal did little to curb the federal deficit.

By Thursday morning, global shares had already run out of steam and were barely treading water, compared to gains of 2 and 3 per cent following the news. If that barometer is anything to go by, then markets will likely remain choppy.

Another political showdown?

Paul Ashworth, chief U.S. economist for Capital Economics, said given the cantankerous nature of the deal-making over the past 10 days it is highly possible to see a similar stand-off in late February or early March. The U.S. budget challenges could also lead to another credit rating downgrade this year, he said.

"Out of the frying pan, into the fire," is how Ashworth characterized the deal and the ensuing battles over spending cuts and the debt ceiling.

Deteriorating relations between leaders in the two parties may especially make for a tense couple of months, experts say.

Vice President Joe Biden and Republican Senate leader Mitch McConnell had to step in to work out the final deal as the relationship between House Speaker John Boehner and Obama broke down, Reuters reported.

Apparently relations between Senate Majority Leader Harry Reid and Boehner are also fractious, with Boehner telling Reid in the White House to "Go f*** yourself" after a tense meeting last week, according to reports.

Failure to reach a deal to increase the nation's debt ceiling -- the current tally is around $16 trillion -- raises the risk of a default on debt, a credit rating downgrade, as well as market chaos.

"It doesn't completely take all of the risks off the table," Craig Fehr, Canadian market strategist at Edward Jones said of the cliff deal.

"What we have so far is at least a little more clarity on where some of the tax increases are going to come from," said Fehr. "But in terms of the fiscal issues still facing the U.S., spending reform -- particularly reform to some long-term entitlement spending -- is likely going to need to take place and that's a very contentious issue and one that is going to probably accompany the debt ceiling debate."

Republicans reportedly vowed the next deal would have to include significant cuts in government benefit programs like Medicare and Medicaid health care.

Down to the nitty gritty

The cliff of tax hikes and spending cuts would have sucked some $600 billion out of the economy this year and tipped the U.S. economy into recession, economists have warned.

Among some of the key elements, the tax hikes that remain will include allowing a 2 per cent increase in payroll taxes on incomes up to $113,700 , removing a benefit that had earlier provided a typical family with about a $1,000 savings, says CIBC's Shenfeld.

Of note is a hike to 39.6 per cent from 35 per cent on incomes over $400,000 (or $450,000 for couples) with the same group also paying higher dividend and capital gains rates.

The parts of the fiscal cliff that were “permanently” addressed included holding personal tax rates on those below $400,000 and indexing the alternative minimum tax to prevent it from hitting millions of additional taxpayers, he said.

"Ultimately, unless the U.S. wants to dig deeply into entitlement spending programs that help the poor and elderly, some of the 'permanent' tax cuts will also have to go, or new revenue sources considered," said Shenfeld.