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Falling Off the Fiscal Cliff

If Congress doesn’t act, current provisions would take $600 billion out of the economy.

November 11, 2012

We live in a strange world. There are laws on the books that will plunge the U.S. economy into another recession early in 2013 unless Congress acts to rescind at least some of them.

In combination, these existing provisions would take about $600 billion, or 4% of gross domestic product (GDP), out of the economy—amounting to a huge fiscal de-stimulus package. This is known as the “fiscal cliff.”

The lion’s share of the fiscal contraction ($430 billion) would come in the form of tax increases.

Major tax reductions first enacted in 2001 were initially set to expire nine years after enactment. This was necessary for the 10-year cost of the tax cuts to pass muster.

The resulting tax increases—to return to 2001 rates—already have been postponed twice, and are due to expire again at the end of this year.

This change would increase tax revenue by almost $300 billion. In addition, the expiration of the temporary 2% Social Security tax holiday of the past two years will increase payroll taxes by slightly more than $100 billion.

Another $30 billion would come from taxes related to the new health-care law ($20 billion) and bonus depreciation rules ($10 billion).

The aftermath of last year’s debt ceiling impasse in Congress will be $100 billion in automatic spending cuts (affectionately referred to as “sequestration”).

Cuts in Medicare payments, the “doc fix” of $20 billion, and $40 billion in savings from the elimination of extended unemployment compensation bring the total spending cuts to around $160 billion.

There will be two consequences if Congress does nothing:

1. The first consequence would be almost immediate, and very bad. If our fragile economy—still a long way from fully recovering from the Great Recession of 2008 to 2009—is hit with $600 billion in combined tax increases and spending cuts in early 2013, the resulting recession likely would push the unemployment rate north of 9% by the end of 2013.

That would be nearly two percentage points higher than what it would be without the fiscal de-stimulus—a huge price to pay.

2. The second consequence would be beneficial, but would take several years to manifest. The $600 billion in tax increases and spending cuts would put a huge dent in the 2013 federal deficit, cutting it by almost half.

Unfortunately, the deficit would fall by less than $600 billion because the economic slowdown caused by the de-stimulus would lower tax receipts somewhat. But, the deficit reduction would be huge.

During the course of several years, the cumulative effect of lower deficits would lead to a noticeable reduction of the national debt, helping to avert a long-term debt crisis.

Even if policy makers decide the short-term pain (another recession) is worth the long-term gain (a more manageable national debt), getting there by jumping off the fiscal cliff isn’t the right way to do it.

The particular revenue increases and spending cuts contained in current law aren’t what most policy makers would choose as the best way to move toward budget balance.

Two aspects of the policy—heavy reliance on tax increases and an arbitrary 50/50 split of defense and nondefense spending cuts—conflict with current policy goals. Effective long-term deficit reduction requires a serious look at all tax and spending categories, including entitlements.

Also, given the weak economy, it would be much better to begin in 2013 to phase in some combination of spending cuts and tax increases rather than doing them all at once.

Most analysts agree on the general approach Congress must take to avoid the worst of the fiscal cliff, while beginning real, long-term deficit reduction. They disagree sharply, however, on the best mix of tax and spending changes.

Any sensible resolution will require compromise, not likely in Congress’s bag of tricks right now.

Realizing this, consumers, businesses, and investors are understandably concerned and cautious. That caution will moderate growth between now and the end of the year.

 BILL HAMPEL is CUNA’s senior vice president of research and policy analysis/chief economist. Contact him at 202-508-6760.