Hamish McRae: So, which way will the US turn?

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The Independent Online

How fast should you cut? Today, we will be preoccupied by the Autumn Statement, or as Labour used to call it, the pre-Budget report. But – and I mean no disrespect to our Chancellor – whatever he does or does not do will make only a marginal difference to the British economy over the next three years and just about zero to the world economy. It matters politically and it matters to us personally, but that is different.

By contrast, what the US does to its budget matters very much and once the hubbub here dies away, the focus will I think shift to the US where the "fiscal cliff" looms. The cliff is the automatic tightening of fiscal policy that happens, in the absence of Congress stopping it, at the end of the year. The cuts in spending and the increases in taxation are equivalent to 4 to 5 per cent of GDP. It would be almost as though we here were doing our five-year squeeze in one fell swoop. But were it to happen, the shock would I think lead to some accommodation in Congress in January that would soften the blow.

Both sides accept that there has to be some sort of deal, one that would trade higher taxes (which the Democrats stress the need for) with lower public spending (which the Republicans want). The question is over the balance. The more likely outcome is that there will be some sort of temporary deal in the next couple of weeks. This would pave the way for a more substantive agreement in the spring, which would be a sensible way to do it.

The problem with the US tax system is that it does not raise very much revenue as a proportion of GDP compared with most Western democracies, but it has quite serious distorting effects on people's behaviour. It is too complicated and combines quite high nominal rates of taxation with too many loopholes.

Take even the basic income tax rate. The top take notionally is 35 per cent, which may not sound that high to us. But you have to add state income tax, the top rate of which could be as high as 9 per cent. So, rich Americans face nominal rates similar to Europeans – they just have more loopholes.

There are two questions, then. One will be whether the deal will show a credible path towards a balanced budget. In other words, at what speed will the US restore fiscal discipline? The other is whether the country will end up with a better designed tax structure.

The first matters a lot to the rest of the world. The US will account for roughly one-third of the incremental demand added to the world next year. So if growth were halved by a botched fiscal deal that would deal a real blow to global demand, which we would feel here. But if Congress were to reach agreement for a five-year plan to balance the budget, it is possible that the boost to domestic confidence would more than offset the mechanical hit to demand from fiscal tightening. Instead of the country growing at the 2 per cent generally expected, it could end up picking up some pace.

The second matters more to the US itself. Its domestic market is so huge that it can, to some extent, get away with a poor tax system. But one effect has been for American companies to move activities, make profits and hold cash offshore – and not just in the tax havens that we've been hearing so much about. Another effect has been to exacerbate inequalities, as wealthy individuals can minimise their tax payments by using the loopholes that the system has deliberately created.

Whether Congress has the ability to reach agreement on substantive reforms is another matter, but if it does, that would have knock-on effects on the rest of us.