Tax increases and spending cuts set to take effect January 1 would likely push the U.S. economy back into recession, says UCI economics associate professor Bill Branch. An expert in macroeconomics, he explains the looming fiscal cliff – a term coined by Federal Reserve Bank chairman Ben Bernanke – as the result of shifting demographic trends, tax cuts and defense spending that increased the federal debt at a time when tax revenues were on a recession-fueled decline. Below, Branch explains in detail what fiscal tightening measures would mean for the average American and what it will take from a polarized Congress to ensure a fall off the cliff is avoided.

What is the fiscal cliff and what could it mean for the U.S. economy, should we go over?

The fiscal cliff is a sharp tightening of fiscal policy that, based on current federal law, will take effect at the beginning of 2013. In January, current law calls for a large combination of tax increases and spending cuts that the Congressional Budget Office (CBO) estimates will cut the size of the federal budget deficit by about 43%. The federal government does not typically change its fiscal policy over such a short time span.

The fiscal cliff is a concern because it could potentially damage the economic recovery in the U.S. Following the collapse of the housing bubble, the U.S. economy experienced a financial crisis and recession that constituted the most severe economic crisis since the Great Depression. The recovery from that recession has been considerably slower than normal. More concerning is the fragile nature of the recovery with the past few years being a series of fits and starts. Policymakers have been concerned about anything that might derail that growth and a sharp fiscal contraction could be such a factor. The combination of higher taxes and less government spending will lead to less demand for goods and services. The Congressional Budget Office (CBO) estimates that the effect of the fiscal cliff will be to shrink real GDP (a measure of economic activity) by 0.5 percent and put the economy back into recession.

How did we get to this point?

To answer this, it is important to separate politics from long-term trends in the federal budget. Most economists agree that the federal budget is on an unsustainable pace.  Regardless of the fiscal cliff, the combination of an aging population and growing entitlement programs (e.g. Medicare, Social Security) will lead to greater and greater amounts of federal debt that will necessarily require fiscal tightening. In advance of these shifting demographic trends, rather than run surpluses, the government has run deficits primarily as a result of a loss of tax revenue during the recession, a series of tax cuts in 2001 and 2003, a large increase in defense spending since 2001, and emergency fiscal measures during the financial crisis and Great Recession.  

Although most everyone agrees that the current fiscal stance is unsustainable, there is bitter political disagreement over the best course of action. Republicans emphasize cutting spending, especially in the entitlement programs. Democrats prefer tax increases, particularly on the wealthiest taxpayers. Because of that disagreement, and some peculiarities in how the budgeting process works, a number of tax cut provisions are set to expire at the same time that a set of across-the-board spending cuts are set to be enacted.  

Some say we've reached a point where drastic measures like this are necessary. Do you agree or is the cliff avoidable?

As an economist, I’m not an expert on what types of threats or drastic measures are necessary for the country’s political leaders to reach consensus on a long-term budget plan. Using common sense, it seems obvious that a fall off the fiscal cliff is avoidable. It is in the country’s best interests and seems to be in the political interests of both Democrats and Republicans. The expiration of the 2001 and 2003 income tax cuts are set to affect households at every level of income. The failure to limit the reach of the alternative minimum tax (that expired over a year ago) will likely lead to unexpectedly high tax bills for many households. Additionally, one would prefer to cut spending in a more measured way than automatic across-the-board cuts. Finally, if the economy were to fall into a recession again it would exact economic pain on the country and likely make the debt problem worse.
 
Avoiding the fall would mean that a very polarized congress would have to come to some sort of compromise. What happens if Republicans get their way in the negotiating process and Dems don't? Vice versa? What will each of these mean for the average American?

Nobody wants to see the across-the-board spending cuts, the increase in taxes for the bottom 98% of all taxpayers, or the greater reach of the alternative minimum tax. The Republicans are pushing for a cut in entitlement benefits that are most likely to affect younger people. In the future, younger workers may need to save more and make plans to supplement the income and health security programs currently offered by the federal government. The Democrats insist on allowing the tax cuts for the top 2% to expire at year’s end, and insist on maintaining future entitlement benefits. The extent to which higher taxes on the top 2% affects the average American depends on whether those higher tax rates on the top 2% negatively affect their incentives to work and invest.  While economic theory is fairly clear that higher marginal tax rates distort incentives to work and start or expand businesses, the evidence on how strong of an actual effect this might be is mixed.

Do you see any indications that the looming cliff and any action that would stop the country’s slide toward it are impacting our economy now?

A number of economists – including Ben Bernanke – have been making the case that uncertainty surrounding the fiscal cliff has been a significant restraint on the economic recovery. Surveys of businesses have cited uncertainty about the fiscal cliff as a reason to delay or cancel hiring or new capital purchases. A recent study by Scott Baker and Nick Bloom from Stanford, along with Steve Davis at the University of Chicago, construct a policy uncertainty index and show that high levels of policy uncertainty can negatively affect the economy.  
 
If no legislative action is taken to stop the tax increases and spending cuts, what can we expect as a country in terms of GDP? Unemployment?

The CBO estimates that if current law extends into 2013 the economy will contract at a 2.9% rate in the first 6 months of 2013, followed by a tepid 1.9% growth during the last 6 months of 2013. They also project that unemployment will rise to 9.1%.

There are reasons to be less pessimistic than the CBO. First, Federal Reserve monetary policy has been very aggressive in providing expansionary policy and there is little doubt that monetary policy will become more accommodative if the fiscal cliff drags on the economy. Second, there are actions that the federal government could take, even if they can’t reach a compromise by Jan. 1, to lessen the burden at the beginning of the year.  For example, although marginal income tax rates are increasing, it is not necessary that the automatic withholding amounts from worker pay checks increase right at the beginning of the year. Third, the CBO’s model of the “multiplier effect” of fiscal policy likely overstates the negative effect that higher taxes, and lower spending, have on the economy. However, because of the fragile nature of the economic recovery, any further head winds could potentially be very damaging to the nation’s economic health.

-Heather Wuebker, Social Sciences Communications
 

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