The Fiscal Cliff Is Not as Steep As It Seems

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Wednesday, 22 August 2012 10:27

The Congressional Budget Office came out with its mid-year budget update. The update included a warning that if the Bush tax cut and the payroll tax cut are both allowed to expire and the cuts from last year's budget agreement take effect, the economy will sink into recession in 2013 and the unemployment rate will rise to 9.0 percent. The NYT immediately picked up on this warning in a news article on the new projections.

It is important to realize that this projection for a shrinking economy and rising unemployment rate is based on the higher taxes and lower spending remaining in place for a whole year. The failure of Congress and the president to agree to a package by January 1, 2013, by itself, would not lead to this sort of contraction.

If Congress and the president were to work an agreement somewhere in the month of January or even February, it would mean that people would be paying higher taxes for a short period of time. This reduction in disposable income, coupled with the cuts in spending scheduled to take place, would dampen growth. However, if an agreement reached early in the year restored part of the tax cuts and reversed some of the spending cuts, then the impact on the economy would be very limited. 

The point is that January 1, 2013 is not a drop dead date. While it would be desirable to have an agreement on tax and spending issues before this date, and in fact as soon as possible, there will be little harm if negotiations continue into next year, as long as a deal is reached before we get too far into the new year.

If the deadline is allowed to pass then it is easy imagine that Congress approves a tax and spending package that prevents a large hit to the economy. If the experts' assessment proves right and President Obama is re-elected, then it is easy to envision a scenario in which he proposes a tax cut to the new Congress that restores the Bush era rates (or something close to them) for the bottom 98 percent of the income distribution. He could even include a temporary further rate reduction to replace the payroll tax holiday. It would be difficult to envision even a Republican controlled Congress refusing to pass a tax cut for 98 percent of taxpayers, which will also be needed to provide a boost to the economy.

The increase in taxes on the wealthiest two percent would have only a modest impact on demand. Much of this money would have been saved otherwise, so the fact that government is pulling it away in taxes is not likely to have much negative effect on consumption.

On the spending side, the cuts of roughly $50 billion from both domestic discretionary and the military will have a negative impact on jobs and growth. It is worth noting in this respect that cuts to the domestic side will almost certainly lead to more job loss than cuts to the military budget. The latter tends to be more capital intensive, so fewer workers are employed per dollar of spending.

While these cuts in spending will clearly slow the economy, this is presumably what Congress wanted when it insisted on spending cuts last year. In other words, it is bad economic policy, but it seems to be the economic policy that Congress insisted on, so this portion of the "cliff" really should not be a surprise to anyone.

Finally, it is worth noting that many of the same people who claim that the stimulus did not create jobs are touting the risk to the economy from the fiscal cliff. It is pretty hard to imagine an economic theory where a cutback in spending leads to a loss of jobs, but an increase in spending doesn't create jobs. In other words, anyone who believes that the stimulus did not create any jobs should not be concerned about the fiscal cliff. By their theory of the economy, it won't have any impact.