Peering Over the Fiscal Cliff
Posted by Rick Miller on December 3, 2012
We’ve been hearing about the fiscal cliff ever since Ben Bernanke coined the term back in February. It sounds pretty scary. If the economy goes off the (fiscal) cliff, it might shatter on the rocks below. That is, if the fall is far enough. And if there really are rocks. And if the economy really is, what, a car?
That’s the problem with metaphors – they are imperfect, often very imperfect, representations of reality. So, let’s look at the reality a little bit more closely, and try to identify what might really happen.
Exactly What is the Fiscal Cliff?
Early in 2013, unless the US Congress passes different laws and the President signs them, several changes to current law will occur simultaneously:
- The Bush tax cuts will expire. Individual income tax rates will rise back to their 1999 levels (between 3% and 5% higher), as will tax rates on dividends (from capital gains rates to ordinary income rates) and capital gains (5% higher).
- The “sequester” will take effect. Back in August 2011, Congress and the President agreed to implement large spending reductions at the beginning of 2013 as part of the deal to increase the US debt limit. Defense spending and discretionary domestic spending would each be reduced by about $65 billion dollars every year for the next 9 years, for a total reduction of $1.2 trillion dollars by 2021.
- The payroll tax cut will expire. Households will again have to pay their full share of Social Security taxes, back to 6.2% from the current 4.2%.
- Emergency unemployment compensation will expire. In response to the high and stubbornly persistent unemployment that came out of the Great Recession, the Congress and the President agreed in 2010 to extend unemployment benefits for up to a year after state benefits expired. They repeated this extension in 2011 and 2012.
- New taxes instituted in the Affordable Care Act will become effective. High income earners will pay .9% of earned income over $200,000 ($250,000 for couples) and 3.8% of investment income over those threshold amounts. [This change is almost certain to occur, and it may not be appropriate to consider it to be part of the fiscal cliff.]
- The alternative minimum tax (AMT) thresholds would return to 1993 levels. Effectively, many more households would be subject to the AMT (which is at a lower rate but allows many fewer deductions than the standard tax system) and would pay higher taxes.
What if We Go Over the Cliff?
Collectively, the changes in the law would raise Federal taxes significantly and cut Federal government spending quite a bit. In addition, there would be substantially smaller spending on defense (Army, Navy, Marine Corps, Air Force, and Coast Guard) and other government spending (FEMA, State Department, Department of Labor, etc.). Spending on “entitlement programs” – Social Security, Medicare, Medicaid – would not be affected.
But, what would all of that mean to you?
First, let’s think about the direct impact on you. If all of the changes occur, it is extremely likely that your personal income taxes would rise. If you work in the defense industry or in a business that depends directly on US government spending, your job might be at risk, or your income might decline, especially if we take a long view, say 5-10 years. If you currently receive extended unemployment benefits, they would stop.
You would also experience indirect impacts through the broader economy and financial asset markets. These effects are much more difficult to assess. Economists do not all agree on how tax increases and government spending decreases affect the overall economy. One estimate of the impact suggests that if all of the changes we described above were to occur, economic growth would slow sufficiently that we would have another recession. That is, the economy might actually get smaller by 1-2% during 2013. Economists who believe that government spending and taxes have smaller effects on the economy as a whole would suggest a less dramatic impact. As to the stock market, we have even less ability to predict. However, it is fair to say that if no legislative resolution is reached, the time between now and the end of the year will be full of news about the negotiations, and there will be a lot of noise (up and down price movements) in the financial markets as a result.
On the other hand, “going over the fiscal cliff” would almost certainly reduce the Federal deficit. Federal revenues would go up, and Federal spending would decrease. Economists and legislators both agree that this would be good (they agree, after all, that deficits and government debt are both too large), but they are concerned about the “short term” effects, which are those I summarized above.
To refer back to the very beginning of this article, as we look over the “fiscal cliff”, it seems to be more like the edge of a shallow mesa or tableland, on a road that slopes gently downward before disappearing off into the distance with a good deal of fog obscuring the horizon. To be sure, the direct effects on all of us will be somewhat unpleasant (no one likes to pay higher taxes), and some of those affected by the cuts will suffer even more. Nevertheless, on balance, I would suggest that the term “cliff” is a dramatic overstatement.
What if We Don’t Go Over the Cliff?
To continue the analogy for just a moment, at the edge of the mesa, imagine multiple roads branching off from where we are. One is the “fiscal cliff.” The others don’t have names, but they all are associated with patterns of increased taxes and reduced spending, and all involve reducing the deficit. (Republicans and Democrats agree that we should reduce our deficit. It’s just that Republicans want to reduce spending, and Democrats want to increase taxes.) Unfortunately, if both increased taxes and spending reductions reduce economic growth (and most economists agree that both do, in the short run), then each of the roads slopes downhill. That is, it’s not a question of fiscal cliff or no fiscal cliff, but which way to go down the hill.
Furthermore, in the longer run, we know that additional changes will be required.
We have two fundamental problems:
1) We have run up a very large debt by reducing taxes without reducing spending, waging two very expensive wars without raising taxes to pay for them and borrowing for bailouts and stimulus to deal with the recent financial crisis. This debt significantly reduces our ability to borrow if we needed to in a time of national emergency, such as another financial crisis or national security threat.
2) Social Security, Medicare and Medicaid are all insolvent (or at least underfunded, in the same way that pension funds can be underfunded), and we will have to raise taxes and / or reduce the dollars spent on benefits if we are to rein in the deficit and keep the debt at manageable levels.
The “fiscal cliff” is just the beginning of the journey.
There is one last point. If increased taxes reduce economic growth, and reduced spending does too, why not reduce taxes and increase spending, or at least, leave things as they are? The answer, of course, is that the Government spending more than it takes in is not a sustainable strategy in the long run – taken to extremes, it ultimately leads to tears, as the Greek example, just one among many, illustrates.
And, by the way, what about Europe?
The European situation continues to muscle its way into our consciousness with some regularity. Greece is still trying to borrow more money from various lenders to overcome its deficit and debt problems. As I have noted before, Greece’s national government regularly spends more than it takes in, and has now grown its debt to more than 140% of its Gross Domestic Product (its national income). The discussion is now about who will take losses, and in some cases, how those losses will be disguised; as it is widely acknowledged that Greece cannot pay the full amount (some private lenders have already taken losses).
In broader terms, the discussion is about how country members of the Eurozone (like Greece, Spain and Portugal) will manage their budgets, and what will happen if a member country’s debts get so large that lenders doubt its creditworthiness. Solvent member countries are unenthusiastic about taking responsibility for debts they did not authorize in the first place, but this is the first time the situation has arisen. The participants (the Eurozone member countries, the European Central Bank, and the International Monetary Fund) seem to be making good progress, but we won’t know the outcome until it actually occurs. We are watching them develop the solution in real time.
The process is very messy and very noisy (that is, there is a lot of news, much of which has no information about the ultimate outcome). It is an abnormal and complex situation, so it is very difficult to understand, and our sensitivity to it is larger because of our recent experience with the Financial Crisis and the Great Recession. Because the numbers are large, this makes financial markets nervous.
Nevertheless, the good news is that most of us realize that the current situation, with governments spending more than they take in, is unsustainable, and we are trying to do something about it.