Misguided “Fiscal Cliff” Fears Pose Challenges to Productive Budget Negotiations
Failure to Extend Tax Cuts Before January Will Not Plunge Economy into Immediate Recession
We released a new
analysis
earlier today that sorts through some of the fears about what
policymakers and pundits are calling the “fiscal cliff”: the income and
payroll tax cuts that will expire and the across-the-board spending
cuts that will take effect — all around New Year’s Day. Here’s the
opening:
The sooner policymakers enact legislation to put the budget on a
sustainable long-term path without threatening the vulnerable economic
recovery, the better. But, as they prepare for an almost certain
post-election "lame duck" session of Congress, policymakers should not
make budget decisions with long-term consequences based on an erroneous
belief: that the economy will immediately plunge into a recession early
next year if the tax and spending changes required under current law
actually take effect on January 2 because policymakers haven't yet
worked out a budget agreement.
Understanding the relationship
between changes to the budget and changes to the economy is critical for
making sound decisions. Policymakers, media, and others widely refer
to the tax and spending changes slated to take effect at the start of
January as the "fiscal cliff." Those changes will not produce an
economic calamity, however, if the measures most damaging to the economy
in the short term are in effect for only a few weeks or even a month or
so while policymakers work toward an agreement. If current law
initially takes effect — causing various income and payroll tax cuts to
expire on January 1, emergency unemployment insurance (UI) to expire
while joblessness remains very high, and across-the-board spending cuts
to kick in on top of the discretionary cuts that the 2011 Budget Control
Act caps mandate — the economy will indeed start down a slope that
could ultimately lead to a recession in 2013. But that's a far cry from
the economy falling off a cliff and plunging immediately into
recession.
In fact, the slope would likely be relatively modest
at first (and then much steeper if 2013 unfolds without a fiscal
resolution). This means that if there is no agreement by January 1,
policymakers will still have some (although limited) time to take steps
to avoid the serious adverse economic consequences that the
Congressional Budget Office (CBO) outlines in its recent analysis of
what will happen if the expiring tax cuts and new spending cuts take
effect on a permanent basis.
[1]
That is, they will have some time to work out the needed compromises
and craft a budget and economic package that can support the recovery
over the next few years while putting in place a balanced package of
spending and revenue measures that will stabilize deficits and debt
(relative to the size of the economy) over the coming decade.
Recent
headlines related to CBO's analysis have fueled visions of a "fiscal
cliff" that produces an immediate economic disaster, but that reflects
some misunderstanding of CBO's analysis. CBO
does estimate
that the budget deficit would fall by $560 billion between fiscal years
2012 and 2013 (3.7 percent of Gross Domestic Product) if policymakers
let current tax and spending law take effect permanently. And because
the policy changes are concentrated around the beginning of calendar
year 2013, the deficit would fall by a somewhat larger amount — 4.7
percent of GDP — if measured on a calendar-year basis, from December
2012 through December 2013.
The economic impact of such fiscal
restraint would be large. The economy would contract at a 1.3 percent
annual rate in the first half of 2013, CBO estimates, before starting to
grow again in the second half at a 2.3 percent annual rate.
[2]
Real (inflation-adjusted) GDP would grow by just 0.5 percent from the
end of 2012 to the end of 2013, and unemployment would rise. With that
outcome, the National Bureau of Economic Research would likely conclude
that the economy was in recession in the first half of the year. No one
should consider that outcome acceptable.
But, much of CBO's
interesting analysis is lost by focusing solely or primarily on the
"fiscal cliff" scenario. CBO's report is, in fact, about the trade-offs
involved in adopting policies to avoid this worst-case short-term
outcome, which policymakers almost surely will do — one way or another.
The question is whether policymakers will respond to frightening
rhetoric about the immediate economic impacts of a "fiscal cliff" by
simply extending current policies and postponing the hard decisions
needed to restore long-term fiscal stability. That would be a serious
mistake and an unnecessary step. As CBO states:
If
policymakers wanted to minimize the short-run costs of narrowing the
deficit very quickly while also minimizing the longer-run costs of
allowing large deficits to persist, they could enact a combination of
policies: changes in taxes and spending that would widen the deficit in
2013 relative to what would occur under current law but that would
reduce deficits later in the decade relative to what would occur if
current policies were extended for a prolonged period.
[3]
Ideally,
policymakers would enact such a package in the next few months. But if
they cannot reach agreement by the end of the year on a balanced plan
of tax and spending changes that will improve both the mid- and
long-term outlook, they should continue to work on it intensively early
in the next year. Suppose policymakers could not work out such a
package until January or even early February 2013 — because it took the
intense political pressure that they would face after failing to reach
agreement by December 31 to move them off some of their rigid positions,
such as opposition to any tax increases to help reduce deficits. That
modest delay could produce a policy that is
better for the
economy over the mid- and long-term than another extension of current
tax and spending policies. To be sure, no one should aspire to a debate
that extends into January or early February. That will not engender
confidence in our political system, and the onset of tax increases and
spending cuts whose duration appears uncertain will cause confusion on
the part of many taxpayers, businesses, and beneficiaries of federal
benefits and services. Nevertheless, a relatively brief implementation
of the tax and spending changes required by current law should cause
little short-term damage to the economy as a whole, since policymakers
would surely make whatever tax and other agreements they worked out in
January or early February retroactive to January 1. Thus, the delay
would withdraw little aggregate demand from the economy.
Politically
speaking, such a scenario would resemble in some respects the
government shutdown in the winter of 1995-96, when President Clinton and
Republican Congressional leaders failed to reach agreement on
legislation to fund government departments and agencies. The intense
political pressure that both sides faced once the shutdown ensued broke
the impasse fairly quickly, and the sides reached agreement that limited
the shutdown to 21 days. This time, with tax increases and spending
cuts taking effect under current law on January 2 amidst a still-weak
economy, the political pressure to reach an agreement quickly would
likely be even greater.
To be clear, the issue of what
policymakers should do later this year or early next on long-term
deficit reduction is distinct from whether they should act much sooner —
in fact, immediately — to provide a further stimulus to an economy that
shows increasing signs of weakness. Last week's disappointing reports
on economic growth and job creation, as well as growing concerns about
Europe's debt crisis and an economic slowdown in China, suggest that
U.S. policymakers should act through both fiscal and monetary policy to
strengthen the U.S. recovery. On the fiscal front, however, they should
be careful to choose policies that will be most cost effective in
boosting demand for goods and services while the economy is weak without
making the nation's long-term fiscal problem worse.
What Would Actually Happen in January?
The
economy will not immediately fall off a cliff into recession the first
week in January if the policy changes mandated by current law take
effect. But what will happen? Table 1 lays out the major expiring tax
and spending provisions and the scheduled spending cuts under the Budget
Control Act's "sequestration" process; together, these changes will
reduce the deficit by $483 billion between fiscal years 2012 and 2013,
according to CBO. Other factors largely beyond policymakers' control
will reduce the deficit by an additional $77 billion, CBO projects, for a
total deficit reduction in 2013 of $560 billion under current law.
[4]
Income, Estate, and Gift Taxes and the AMT "Patch"
Policymakers
in 2010 extended through December 31, 2012 the Bush-era tax cuts, along
with the 2009 Recovery Act's expansions in several tax credits. They
also limited the reach of the alternative minimum tax (AMT) in 2011 but
did not similarly "patch" the AMT for 2012. Altogether, the scheduled
expiration of these provisions accounts for nearly half (46 percent) of
the $483 billion reduction in the deficit between 2012 and 2013 that is
due to the expiration of various tax cuts and spending increases plus
sequestration (and almost 40 percent of the total $560 billion reduction
in the deficit in 2013).
Table 1
Reduction in the Budget Deficit Under Current Law
Between Fiscal Years 2012 and 2013 |
| Provision | Reduction in deficit (billions of dollars) | Percent of expiring tax cuts and spending increases, plus sequestration | Percent of total reduction in deficit |
| Expiration of 2001, 2003, and 2009 tax cuts and indexing of the Alternative Minimum Tax (AMT) for inflation | $221 | 46% | 39% |
| Expiration of 2% payroll tax cut | $95 | 20% | 17% |
| Expiration of federal emergency unemployment insurance (UI) | $26 | 5% | 5% |
| Other expiring tax provisions | $65 | 13% | 12% |
| Across-the-board spending cuts ("sequestration") under Budget Control Act of 2011 | $65 | 13% | 12% |
| Reduction in Medicare payment rates for physicians | $11 | 2% | 2% |
| Total from expiration of tax cuts and spending increases, plus sequestration | $483 | 100% | 86% |
| Other changes in revenue and spending, including effects of economic feedbacka | $77 |
| 14% |
| Total reduction in deficit | $560 |
| 100% |
Source: Congressional Budget Office
a Includes $105 billion of other changes in revenues and spending not
due to specific policy changes (apparently primarily reflecting the
effects of economic growth) plus $18 billion from revenue measures in
the Affordable Care Act that take effect in 2013, minus $47 billion
from the effects of "economic feedback" on the deficit (the fact that
substantial fiscal restraint will slow the economy, reducing revenue and
increasing spending on programs such as unemployment insurance) , and
correction for rounding. |
But
these individual income tax changes will not reduce taxpayers' cash
flow on January 1 by anything like the full revenue increase they would
produce over the course of the year. As CBO states, the immediate
impact on most households' cash flow will be limited to an increase in
taxes withheld from their weekly or monthly paychecks, while those
taxpayers newly falling within the reach of the AMT in 2012 will not
actually pay those higher taxes until they file their returns in
subsequent months.
[5]
In addition, there is broad bipartisan agreement that most of the middle-class income-tax cuts should
not
expire in 2013 and that the AMT should continue to apply only to more
affluent households. Thus, middle-class taxpayers might reasonably
expect that they would not ultimately bear any additional burden in 2013
from higher tax rates or an expanded AMT. As long as they have reason
to expect that Congress will rescind the increase in the tax rates and
patch the AMT before March or April, many affected taxpayers, especially
those with savings, might well maintain most (or all) of their spending
over the first couple of months.
[6]
For
the health of the economy in 2013-14, the important issue with respect
to the tax cuts is to ensure that tax cuts for low- and moderate-income
households do not expire; the fate of the Bush tax cuts for the top 2 to
3 percent of taxpayers should be of little economic consequence in 2013
and 2014. Moreover, if only the tax cuts for lower- and middle-income
households are extended, high-income taxpayers will still benefit from
the reduced tax rates on the full portion of their income that falls in
the lower tax brackets. CBO's analysis indicates that a cost-effective
way to continue using the tax cuts to shore up the weak economy would be
to extend the middle-class tax cuts for a year or two, allow the
upper-income tax cuts to expire, and extend the tax-credit expansions
targeted on low- and moderate-income households. Such an approach would
provide the most "bang-for-the-buck" in terms of supporting the
economic recovery in 2013-14 without seriously compromising long-term
fiscal sustainability.
- As CBO says in its analysis of
how different policies affect spending in a weak economy, allowing the
rate increases for the top brackets to go into effect while deferring
the other scheduled rate increases would be "more cost-effective in
boosting output and employment in the short-run" — i.e., it would do
more to increase growth and jobs per dollar of cost — than deferring all of the scheduled tax-rate increases.[7]
The reason is that higher-income households would spend a smaller
fraction of any increase in their after-tax income than the typical
household would. In other words, the cost in terms of forgone
short-term stimulus from allowing the top rates to rise in order to
reduce the deficit would be much smaller than the cost of allowing the
rates for middle- and lower-income households to increase.
- For
analogous reasons, a higher tax rate and lower exemption level for the
estate tax would almost surely exert even less restraint on growth and
have even less effect on the economy in 2013-14 than the very small
effect from allowing the increase in upper-bracket income tax rates to
take effect.
- CBO goes on to suggest that it is far more
cost effective to provide (or continue) tax cuts to lower-income
households, who would be more likely than both middle-class and
high-income households to spend a large share of any additional
after-tax income they receive.
The Payroll Tax Cut and Emergency Unemployment Insurance
Legislation
enacted this February extended through this year the
two-percentage-point cut in the payroll tax that first went into effect
in January 2011 (replacing the Making Work Pay tax credit enacted in the
Recovery Act). The same legislation extended federal emergency
unemployment insurance (UI) through the end of 2012 but provided fewer
weeks of UI benefits to the long-term unemployed than were available
between late 2009 and the end of 2011.
[8]
Both provisions expire at the end of this year, and those expirations
account for about a quarter of CBO's estimated $483 billion reduction in
the deficit between 2012 and 2013 that is due to expiring tax and
spending provisions plus sequestration (and a fifth of the total $560
billion reduction in the deficit).
Expiration of the payroll tax
cut and federal emergency UI would affect households' cash flow in much
the same way as expiration of the middle-class tax cuts. A worker's
weekly or monthly paycheck would be smaller due to the higher payroll
tax deduction; an unemployed worker's weekly income would be lower
without UI. The impact in the first month or so would be only a
fraction of the year-long impact.
CBO estimates that the
effects on output and employment of the payroll tax cut's expiration
would be fairly similar to those of the middle-class tax cuts'
expiration. The payroll tax cut is somewhat better targeted as stimulus
than individual income tax cuts — a higher proportion goes to
moderate-income workers, who likely will spend rather than save most of
it — but not as well targeted as the refundable tax-credit expansions
targeted to low- and moderate-income taxpayers that Congress enacted in
the Recovery Act and extended in 2010.
As for letting federal
emergency UI expire, CBO judges UI to be one of the most cost-effective
policies for boosting output and employment in a weak economy. Although
the amount of UI spending that would be lost is much smaller than the
amount of the payroll tax cut, the bang-for-the-buck of UI spending is
higher.
Unfortunately, there appears to be less support in
Congress for extending the payroll tax cut (or enacting a
better-targeted temporary tax cut) than for extending the middle-class
tax cuts. As a result, if there is no agreement by December 31,
middle-income households will be more likely to adjust their spending
immediately in response to the higher deduction of payroll taxes from
their paychecks than in response to a rise in income tax rates that they
expect will soon be rescinded.
Although Congress has extended
federal emergency UI several times since enacting it in 2008, support
among lawmakers for recent extensions has been mixed, and another
extension is likely to prove difficult to achieve — even though the
highest unemployment rate at which federal unemployment benefits have
been cut off in the past was 7.2 percent,
[9] a rate no one expects the economy to be close to at the end of 2012.
In
sum, expiration of both the payroll-tax cut and federal emergency UI
will likely exert more of an immediate restraint on the economy than
expiration of the income and estate tax cuts will. This is because
expectations will be much lower that Congress would reinstate the former
in a new budget deal and because the people receiving UI and the
payroll tax cut are, on average, much more likely to spend much or most
of any additional income they receive. Even here, however, only a
fraction of the ultimate economic impact of those expirations will be
felt in the first month or two.
Across-the-Board Spending Cuts Mandated by the Budget Control Act
In
addition to imposing caps on discretionary programs that will reduce
their funding by about $1 trillion over the ten years from 2012 through
2021, the Budget Control Act (BCA) of 2011 established an automatic
enforcement procedure called sequestration — a form of automatic
spending cuts that apply across a substantial part of the budget — that
is scheduled to first take effect in January 2013. CBO estimates that
sequestration will account for about 13 percent of the $483 billion
reduction in the deficit between 2012 and 2013 that is due to expiring
tax and spending provisions plus sequestration (and about 12 percent of
the total $560 billion reduction in the deficit).
Sequestration
calls for a reduction in spending authority of $109.3 billion each year
from 2013 through 2021, split evenly between defense and non-defense
programs.
[10] While the limit on spending
authority will be imposed at the beginning of the year, the
actual reductions in spending
will occur over the course of the year and into subsequent fiscal
years. Once again, only a fraction of the impact occurs in the first
month or so, although expectations of the cutbacks can affect the
behavior of government contractors and others in advance of the actual
cuts.
Policymakers designed sequestration to prompt the Joint
Select Committee on Deficit Reduction created by the BCA to propose
legislation that would reduce deficits by at least $1.2 trillion over
ten years, but the Joint Select Committee failed to come up with such
legislation. While sequestration is highly unpopular with lawmakers,
there is no agreement at this point on what to put in its place. The
President's 2013 budget proposes eliminating all sequestrations through
2021; instead, it would achieve more than the scheduled savings through a
mix of revenue increases and reductions in mandatory programs that
wouldn't have a substantial impact on the most vulnerable families and
individuals and would largely take effect after 2013, when the economy
is expected to be stronger. The House of Representatives has passed a
bill to eliminate sequestration just for 2013 (and just for
discretionary programs), replacing it with a package that hits hard at
programs for low- and moderate-income people while failing to raise any
revenue.
[11]
Thus,
government agencies, government contractors, and others face
uncertainty about how sequestration will play out. Much will depend on
the signals policymakers send about the kind of longer-run budget deal
they are likely to strike and the guidance agency officials receive
about how to conduct business in the meantime.
The best policy
would be to replace sequestration with at least an equivalent amount of
deficit reduction that occurs with much less force in the first few
years and more in the later years, in order to minimize the restraint it
imposes on the economy in 2013-14.
Other Tax and Spending Changes
The
policies just discussed account for 85 percent of the $483 billion
reduction in the deficit between 2012 and 2013 that is due to expiring
tax and spending provisions and sequestration. In CBO's accounting, the
remaining 15 percent of that reduction comes from:
- other
expiring tax provisions, popularly known as "extenders" (13 percent),
the largest of which is the scheduled expiration at the end of 2012 of
partial expensing of investment in plant and equipment; and
- the scheduled reduction in Medicare's payment rates for physicians (2 percent).
In addition to the above $483 billion, another $77 billion of deficit reduction in 2013 comes from:
- what
CBO calls "other changes in revenues and spending not linked to
specific policies" ($105 billion), which appears to primarily reflect
changes in revenues associated with the underlying growth in the economy
from 2012 to 2013 and is partially offset by $47 billion in higher
deficits due to the adverse economic impact from the scheduled tax
increases and spending cuts; and
- $18 billion of new
revenues that will result from a few revenue-raising provisions of the
Affordable Care Act taking effect in January 2013, primarily an increase
in Medicare taxes on high-income taxpayers.
The only
potentially large one of these changes under policymakers' control is
the scheduled expiration of partial expensing of certain business
investments at the end of 2012. CBO does not analyze the effects of
this particular policy on economic growth and employment, but it argues
that extending
full expensing (which expired at the end of
2011) through 2012 would have had a bang-for-the-buck comparable to the
payroll tax cut. CBO also notes, however, that firms are less likely to
increase investment when they have idle capacity, as they do now, and
that the largest effect of this policy in spurring increased investment
is likely to occur just before it expires.
The expiration of
partial expensing at the end of 2012, whether on a temporary or a
permanent basis, would likely impose little restraint on the economy in
early 2013. Firms hoping their business might pick up in 2013 might
move up new investments to late 2012 if they expect the expiration to be
permanent. Conversely, if firms expect Congress to extend partial
expensing into 2013, they might defer investments until later in 2013,
waiting to see if business does indeed pick up.
Conclusion
The
federal budget is expected to shrink dramatically between 2012 and 2013
if the laws governing revenues and spending remain largely unchanged.
With no action from policymakers, that sharp reduction in the deficit
would slow the economy dramatically, likely creating a mild recession in
2013.
Even under that scenario, however, the economy will not
go over a cliff and immediately plunge into another Great Recession in
the first week of January. Rather, most households will begin to
receive somewhat smaller paychecks due to higher income tax rates and
the expiration of the payroll tax cut, but the impact on their cash flow
would play out over the year rather than being concentrated in
January. More important, there is bipartisan support for extending most
of the middle-income tax cuts through 2013, so the impact of a
temporary expiration of the tax cuts on consumer spending is likely to
be modest, given the very high likelihood that lawmakers will end up
extending them retroactively to January 1, 2013 if they haven't acted by
New Year's Day.
The greater danger is that misguided fears
about the economy going over a "fiscal cliff" into another Great
Recession will lead policymakers to believe they have to take some
action, no matter how ill-conceived and damaging to long-term deficit
reduction, before the end of the year, rather than craft a balanced plan
that supports the economic recovery in the short term and promotes
fiscal stabilization in the intermediate and longer run.
End notes:
[1] Congressional Budget Office,
Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013, May 2012
, http://www.cbo.gov/sites/default/files/cbofiles/attachments/FiscalRestraint_0.pdf.
[2]
CBO also estimates that if businesses and households anticipated that
these changes would take place, they would take anticipatory actions
that could shave 0.5 percent off economic growth in the second half of
2012. CBO makes its baseline economic and budget estimates under the
assumption that current laws generally remain unchanged. Private
forecasters are unlikely to make a similar assumption because they do
not expect policymakers to allow most of the changes required under
current law to actually take place. Hence, their forecasts for the
second half of 2012 would anticipate less fiscal restraint in 2013 than
is in the CBO baseline.
[3] CBO,
op. cit., p.2
[4]
CBO estimates that the deficit would fall by $607 billion if that
fiscal restraint had no effect on the economy. In fact, however, CBO
estimates that the restraint would slow the economy, lowering taxable
incomes (and hence revenues) and increasing spending on programs like
unemployment insurance. These "economic feedback" effects add $47
billion to the deficit, resulting in a net reduction in CBO's estimate
of the deficit of $560 billion between fiscal years 2012 and 2013.
[5]
CBO states that the non-AMT changes to individual income taxes “will
affect tax payments beginning in calendar year 2013, when withholding
schedules will reflect those expirations,” and the increase in AMT
liabilities for 2012 “will not be paid by most taxpayers until calendar
year 2013, as they file their 2012 returns.” CBO, op. cit., p. 3.
[6]
They would be even more likely to maintain their spending if changes to
the withholding tables required by the expiration of the tax cuts were
delayed or some other administrative change were taken that would leave
households' cash flow unaffected in anticipation of an extension of the
middle-class tax cuts. At the moment, it's not clear that such steps
would be feasible.
[7]
Congressional Budget Office, "Policies for Increasing Economic Growth
and Employment in 2012 and 2013," Statement of Douglas W. Elmendorf,
Director, before the Committee on the Budget, United States Senate,
November 15, 2011, p. 33,
http://www.cbo.gov/sites/default/files/cbofiles/attachments/11-15-Outlook_Stimulus_Testimony.pdf.
[8]
For details, see Hannah Shaw and Chad Stone, "Conference Agreement Far
Better for Unemployed Workers and UI System Than Original House Bill,"
Center on Budget and Policy Priorities, February 17, 2012,
http://www.cbpp.org/cms/index.cfm?fa=view&id=3686.
[9]
Chad Stone and Hannah Shaw, "Emergency Unemployment Insurance Benefits
Remain Critical for the Economy," Center on Budget and Policy
Priorities, November 10, 2010,
http://www.cbpp.org/cms/index.cfm?fa=view&id=3320.
[10]
For details see Richard Kogan, "How the Across-the-Board Cuts in the
Budget Control Act Will Work," Center on Budget and Policy Priorities,
revised April 27, 2012,
http://www.cbpp.org/cms/index.cfm?fa=view&id=3635.
[11]
Robert Greenstein and Richard Kogan, "House Budget Bills Would Target
Programs for Lower-Income Families While Breaking Last Summer's
Bipartisan Deal," Center on Budget and Policy Priorities, updated May
10, 2012,
http://www.cbpp.org/cms/index.cfm?fa=view&id=3767.
,
provides an excellent and detailed discussion of the many dimensions of
this idea and its relevance to the capitalism we experience in 2012. It
includes contributions by a number of important younger political
philosophers. 
:
.)
