The Corner

The Fiscal Cliff

The Congressional Budget Office (CBO) kicked the budgetary hornet’s nest with its forecast that the U.S. faces a recession unless action is undertaken to avoid the sharp tax increase and across-the-board spending cuts that will result from the sunset of the 2001/2003 tax laws and Budget Control Act (BCA) sequester, respectively.

Of course, this is avoidable if Congress acts to not only avoid the cliff that looms at the end of 2012, but also finally acts in a substantive way to deal with the long-term issues that continue to drive us toward this cliff. The CBO notably points out that Congress ought to undertake real efforts to control the current and projected federal debt load. So, ideally one should substitute mandatory spending controls (entitlement reform) for the sequester because mandatory spending is the budget problem and because the sequester exists only because the so-called super committee did not agree on mandatory spending reforms. That would both eliminate the sequester component of the cliff and take control of the U.S. fiscal future. Then, the explosive tax hike and damaging anti-growth tax policy should be replaced by a comprehensive, pro-growth and pro-competitiveness tax reform (see here).

Viewed from a pure policy perspective, this is a big deal. Given the continued weak state of the economic recovery, it is inconceivable that growth would survive the hit of such a sharp (4 percent of GDP) fiscal contraction. Combine that with the supply-side impact of sharply higher marginal rates, especially on the return to investment, and you have a recipe for the fiscal cliff to induce an economic tsunami.

The very fact that the CBO announced this dire forecast is proof of how serious the situation is. It is the first time in memory that CBO has forecast a recession. Some will point out that the study was done at the request of a senator. True, but most CBO studies are in response to a request, and they don’t include a recession forecast. This is without question a big deal.

#more#The only flaw with the CBO report is that it left the impression that the danger does not arise until the end of the year. Unfortunately, the economy is not that lucky. Instead, as investors contemplate the possibility that the tax rate on dividend income will rise from 15 percent to 44 percent, they will churn out of dividend-paying stocks, and perhaps out of equities altogether. Financial-market turbulence will translate to an economic downshift well in advance of December.

Similarly, the sequester will begin to haunt the federal contracting community well in advance of January. As agencies squirrel away funds in anticipation of the cuts, contractors will get the bad news in August and September as the new fiscal year approaches. This will be exacerbated by the unwillingness of the Obama administration to provide any guidance whatsoever on the mechanics and the ill-advised commitment of Senate Majority Leader Harry Reid. Get ready for a bumpy late summer and fall.

The conventional wisdom is that a complete fix is a bargain too grand to be struck in 2012, and that is probably right. But there ought to be a bridge over the fiscal cliff so that November’s electoral winners can choose a permanent direction for the U.S. in 2013. 

That bridge would merely serve as a way to avoid the sequester, as an extension of current tax policy, and as a commitment to fiscal sanity. Interestingly, the House has already passed a bill to substitute mandatory spending reforms for the 2013 sequester, will soon pass a temporary extension of the 2001/2003 tax laws, and has in place a budget that ultimately eliminates federal debt entirely.

Under regular order, the next step would be for the Senate to do exactly the same thing, a conference committee would resolve differences, the president would whip votes needed to pass the result and the U.S. would be spared a self-inflicted economic wound. Unfortunately, Majority Leader Reid refuses to take any action and the president is missing in action entirely. It is hard to make the process work with two-thirds of the leadership indifferent to the economic welfare of the country.

I keep hearing that politics are broken. Maybe. But shouldn’t Reid at least put the key in the ignition and see if it can get started?

The fiscal cliff is real and the CBO report shines a bright light on the danger. The tax and spending threats that constitute the fiscal cliff are intimately connected to the longer-run budget issues that must be addressed. There may be no consensus regarding the resolution of those larger, permanent issues but there should be an obvious bipartisan path to avoiding the near-term danger. 


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