This week, the Congressional Budget Office released its assessment of the probable economic and fiscal consequences of the “fiscal cliff,” the combination of dramatic tax increases and spending reductions which represent current law for FY 2013 (“fiscal restraint” is the CBO’s preferred nomenclature).
It’s highly unlikely that all of the “fiscal cliff” adjustments would happen, but what if they did? According to the CBO, the U.S. economy would go into recession in the first two quarters of 2013, shrinking by a 1.3 percent annualized rate. Growth would return in the second half of the year (ignoring, though, the possibility that a U.S. recession would drag the rest of the world down with it), with the economy growing just .5 percent in the 2013 calendar year. Earlier estimates provide one even more disturbing number: Current law would force the unemployment rate back up to 9.3 percent by the end of 2013.
What’s this the result of? On the tax side, the entirety of the Bush tax cuts are expected to expire ($221 billion); a few Obamacare taxes, including those on dividends, will kick in ($18 billion); the payroll-tax cut will expire ($95 billion). On the spending side, the debt-ceiling deal’s sequester will reduce expected spending by $65 billion (about half defense and half non-defense); unemployment extensions will expire ($26 billion); and Medicare reimbursement rates will start to be cut ($11 billion).
This is the kind of austerity which, as Veronique de Rugy has covered here, has hobbled Europe: large tax increases and minimal, almost putative, spending cuts (though, it should be said, the sequester represents much more significant spending cuts than any “fiscal conservatives” in Congress have seriously suggested).
Before these specific numbers were released, investors had suggested that the expected fiscal adjustment was already negatively affecting economic expectations. In particular, tax rates on dividends are going to increase dramatically (to as high as 44 percent), causing a potentially huge drop in the equity markets.
The upside? Letting current law lie would reduce the 2013 deficit by $607 billion, or 4 percent of GDP, from 2012 (the actual deficit will depend on how spending is otherwise appropriated). Dynamically scored (taking into account the economic disaster), the CBO says the deficit will be reduced by $550 billion year-to-year.
The counterfactual is that the CBO projects, if current policy is extended, that economic growth will be in a range around 4.4 percent — this almost surely wouldn’t happen, though, as that kind of expected growth would mean a tightening of monetary policy.
All of these various adjustments will be debated in Congress, and, one hopes, sooner rather than later. On spending, Republicans seem to be adamant that the defense half of the sequester not go through, while Democrats have expressed willingness to allow the entirety of it to pass. It is unlikely that the payroll-tax cut, dramatic and broad-based as its effects are, will be eliminated entirely, though one might hope it could start to be phased out. Finally, the biggest single item, the $221 billion in income-tax cuts, will be another point of contention: Presumably Democrats will call to let the cuts expire for upper-income earners, but this would be a relatively small fraction of the overall cost (about $30 billion for just the rate reductions on the top two marginal rates); serious fiscal consolidation on the revenue side would require their full expiration.
Veronique de Rugy has written much in this space lamenting that “austerity” in Europe has meant huge tax hikes and minimal spending reductions, and that, not public-sector discipline, is what has caused Europe’s recent stagnation. Indeed, the CBO seems to agree: The “fiscal cliff” would hugely reduce our deficit, but that consolidation would come mostly via tax increases, and it would have disastrous economic effects here as it has in Europe.