When Federal Reserve Chairman Ben Bernanke, Pimco chief executive Mohamed el-Erian and the Economist all say we should worry about something, we usually should.
Right now they’re warning about the “fiscal cliff” – spending cuts and higher tax rates that will take effect on Jan. 1 unless Congress acts.
In March, the Congressional Budget Office calculated that the fiscal cliff will suddenly subtract $388 billion from the economy in fiscal 2013 (from Oct. 1, 2012, to Sept. 30, 2013), an amount equal to roughly 2.5 percent of national output.
That in turn would hurt growth, possibly boosting unemployment above what it would otherwise be. Economist David Greenlaw of Morgan Stanley thinks the fiscal cliff could cut 1 percentage point from economic growth.
Still, I’m not freaking out. There are reasons to doubt Congress will let the full fiscal cliff materialize and that what does happen may not be all that devastating. In fact, here and there, the benefits of tightening might outweigh the costs.
An example of the latter is the Social Security payroll tax cut (which is not included in CBO’s estimate). In February, Congress extended the cut, along with unemployment benefits, through the end of this year. Yes, the cut’s expiration would hit working families right in the paycheck and curb consumer spending a bit. But extending the cut would rob Social Security of needed cash.
The improving jobs picture also makes extended unemployment benefits less indispensable; at the margins, they may dull the incentive to seek a job.
The CBO’s $388 billion estimate assumes the expiration of all temporary tax provisions in current law. But one such item is the $89 billion “patch” Congress applied to the alternative minimum tax. No matter how polarized Capitol Hill may be, it has always patched the AMT, and it’s a safe bet that’ll happen again.
One of the largest spending cuts in current law is an across-the-board reduction in how much Medicare pays physicians. As with the AMT patch, Congress has always come up with “doc fixes” for Medicare in the past, and chances are it will again.
These steps would reduce CBO’s estimated fiscal cliff to $280 billion, according to Deutsche Bank economist Joseph Lavorgna. But even that number may overstate matters.
The CBO counts the expiration of accelerated capital depreciation for businesses as a $45 billion tax increase. As Lavorgna explains, this is a bit of a misnomer since not every business can take advantage of this targeted break.
Many economists think that as an economic stimulus, accelerated depreciation delivers relatively little bang for the buck – which implies that eliminating it would not hurt growth as much as would other measures. Maybe it’s a good thing to let capital allocation follow market signals rather than tax advantages.
Now we’re down to $235 billion. Of that, the biggest item is $102 billion from the end of the Bush tax cuts. What to do about them is likely to be hugely controversial – but only for upper-income taxpayers. President Obama supports the lower- and middle-income Bush rates, so expect those to remain if he’s re-elected. Mitt Romney, of course, wants the Bush rates, or something like them, to be permanent. At most, we’re looking at some uncertainty until after November, when Congress and the president will iron things out.
That leaves $133 billion, much of which comes from tax-break bits and pieces, including corporate welfare like the biodiesel fuel credit ($1.1 billion). Good riddance to them if they lapse.
What remains are $60 billion in spending cuts, resulting from “sequestration,” as the automatic cuts in last year’s debt-ceiling agreement are known. No doubt these cuts are controversial, and a blunt instrument. Republicans in the House are already fighting to save defense spending; Democrats are condemning them for doing so at the expense of social programs. It’s doubtful the Senate will act on any bill the House produces. But whatever happens, $60 billion is small change compared with the $15.4 trillion U.S. economy.
The best solution would be a “grand bargain” that reforms the tax code and entitlements, and gradually sets the country on a sustainable long-term path. Alas, this is also the least likely solution. We’re in for some fiscal tightening and some spectacular political fireworks. In the end, though, the actual threat to economic growth may be more manageable than it now seems.