Ezrati’s Economic Outlook: The Fiscal Cliff

Congress isn't Thelma and Louise. Legislators are likely to take action to stop or postpone looming tax hikes and spending cuts after the election.

The Congressional Budget Office (CBO) released a sobering report last month entitled Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013. It reminds all that in the absence of some action, the nation faces automatic spending cuts and tax increase in January—a “fiscal cliff,” to use the phrase popularized by Federal Reserve Chairman Ben Bernanke—that would likely turn the already weak economic recovery to recession. It is hard to argue with the CBO’s conclusions on the economic effects, but it is still reasonable to ask if even this Congress, even in a lame duck session after the election, would allow such a thing to happen. Probabilities suggest the answer to that question is “no,” that Congress will avoid economic suicide, allowing the economy’s admittedly plodding recovery to continue.

The CBO report identifies eight elements of this looming fiscal drag: five automatic tax hikes and three automatic spending cuts. It estimates their total impact for fiscal 2013 at $607 billion or some 4% of GDP, enough to turn positive growth negative.

Scheduled tax hikes amount to $399 billion, some two-thirds of the total. These include $221 billion from the expiration of the Bush tax cuts and last year’s decision not to limit the reach of alternative minimum tax (AMT). The AMT matter applies to 2012 earnings but will burden taxpayers’ cash flows only after they calculate their full liability in 2013. Also scheduled is an automatic $95 billion tax hike from the expiration of the two percentage-point payroll tax holiday; a $65 billion tax increase from the expiration of rules allowing businesses to expense investment property; and an $18 billion hike, built into 2010’s Obamacare legislation, on the earnings of high-income tax payers.

On the spending side, there are $208 billion in cuts and scheduled fee increases. These include the so-called sequestration of discretionary spending, mandated by the Budget Control Act that emerged last year from the debt ceiling debate, which would cut some $65 billion out of federal spending for the year. The end of extended unemployment benefits, according to the CBO, should cut $26 billion, and the scheduled reduction in payments to doctors under Medicare should cut another $11 billion. A large number of smaller items, also scheduled to go into effect in 2013, sum to an additional $105 billion in spending restraint.

If this fiscal restraint is allowed to go forward, the CBO estimates that it would precipitate a recession in the first half of 2013, with real GDP dropping at a 1.3% annual rate. A modest recovery during the second half would allow, by CBO calculations, a mere 0.5% growth for the year as a whole, down from an earlier CBO forecast of 1.1% real GDP growth in 2013.

Since even Congress cannot ignore such a dire prospect, it’s likely representatives and senators will take action to stop or postpone these otherwise automatic effects. Doubtless they will wait for a lame duck session after the election. The give-and-take of compromise on these points is much too politically explosive for any of them to deal with before election day. But later in November and in December, there is ample time for Washington to generate at least a temporary fix to avoid driving the economy off this cliff.

Congress can easily postpone the spending cuts that are scheduled. Last year’s Budget Control Act is, after all, a product of Congress and subject to its subsequent votes. Legislators could easily push sequestration out for at least a year and perhaps indefinitely. Similarly, Congress should have little trouble postponing the reduction in doctors’ payments. This postponement has become an annual event, in fact, so regular that it has acquired the nickname “doc fix.” And Congress should have little difficulty softening the end of extended unemployment benefits. They were part of a fiscal compromise in 2010. A gradual decay in the amount of required spending seems a plausible approach.

The tax side is more complex but not insurmountable. The parties are farthest apart on the expiration of the Bush tax cuts. Democrats want to continue the tax relief only for lower-income people, those individuals who make less than $200,000 a year and those couples who make less than $250,000 a year. Republicans want to continue the tax relief for all. Since all the tax relief would otherwise disappear automatically, the Republicans will threaten, as they did when this came up in 2010, to vote down anything but complete renewal.

Despite the appearance here of an impasse, tax reform might offer a way out. In recent years, both Republicans and Democrats have proposed reforms that would reduce the statutory rate and broaden the tax base by eliminating tax breaks and credits. These could appeal, especially when neither party has the luxury of inaction. A reform effort would enable either party to sidestep AMT and Obamacare tax matters. Because of the impasse over the Bush tax cuts, reform would also enable both parties to avoid the label of tax increases. For Republicans, reform would further appeal by offering elements of the growth-oriented tax efficiencies that the party has embraced in the past, most recently in the Ryan plan. Republicans might even allow a net tax increase, if associated with reforms that would allow them to offer their constituents a drop in the statutory rate. Tax reforms would allow Democrats to sidestep accusations of class warfare and avoid the risk that an impasse would force tax hikes on their lower-income constituencies. They also would embrace the broadening, since, rhetoric aside, they know that tax hikes on the wealthy alone cannot close the budget gap.

More cynically, even if Congress is still far from agreement, discussion of reform could serve as an excuse to avoid the cliff. Both sides could claim they will accept a continuation of current law for some months or a year in order to work out the details of more serious and lasting tax reform. It would at least avoid the appearance of kicking the can down the road. If they’re sincere, the country might actually get a more efficient, simpler, more growth-oriented tax code. If discussion of reform is a pose to avoid a difficult vote, it would at least keep the economy from driving off the “fiscal cliff.” In either case, the recovery misses the downside, which the CBO has detailed, and continues its otherwise plodding recovery.

 

 

About the Author

Milton Ezrati

Milton Ezrati

Milton Ezrati is senior economist and market strategist for Lord Abbett & Co. and an affiliate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo. His latest book, Thirty Tomorrows, linking aging demographics and globalization, will appear next summer from Thomas Dunne Books of St. Martin’s Press. See more of his articles about the economy here.

 

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