Well the officers are trying to keep me down, trying to drive me underground. And they think that they have got the battle won, so as sure as the sun will shine I’m gonna get my share now of what’s mine. And then the harder they come the harder they’ll fall, one and all. Ooh the harder they come the harder they’ll fall, one and all. So sang Jimmy Cliff in 1972. And just like in 1972, the US economy is facing a crisis. Then it was the Arab Oil Embargo. Today it is the Jimmy – er Fiscal – Cliff.
The Fiscal Cliff is a term coined by Federal Reserve Chairman Ben Bernanke, in February of 2012 when he told the House Financial Services Committee that a massive fiscal cliff of large spending cuts and tax increases would take place on January 1, 2013. While this is a great term and makes for good headlines, one can really question whether or not the tax increases and minor spending sequesters at the beginning of the year will really amount to anything worrisome.
Let’s take the easy thing first. On January 1, 2013, current law calls for a mandatory sequestration of funds totaling $110 billion per year which will be applied from 2013 to 2022, split evenly between defense and non-defense discretionary spending. The Congressional Budget Office estimates that this would equal $65 billion in the coming year, so for fiscal year 2013, these cuts amount to about a spit in the ocean and will really have no effect either on government programs or the economy.
The tax increases, on the other hand, will impact nearly everyone in the country. As of January, income tax rates will increase for all taxpayers back to what they were during the Clinton Administration. In addition, Social Security taxes will increase for all workers by 2 percentage points, Alternative Minimum Tax will fall back to their 2000 tax year levels placing nearly every family that works into the AMT, hundreds of business tax break extenders will expire, the Inheritance Tax will go back into effect, and dozens of new taxes imposed as part of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 will go into effect. On top of this, Medicare payment rates to doctors will fall substantially and federal unemployment benefit extenders will expire.
All in all, the Congressional Budget Office estimates that these tax provisions would equate to a one-year tax increase of $399 billion. This is a fairly significant tax increase considering that total Federal revenues in 2012 are estimated to be $2.44 trillion. In other words, this is a 16 percent tax increase.
It appears unlikely that the President and Congress are going be able to forestall this cliff. In fact, the President campaigned on a platform of increasing taxes so it is really in his interest to simply allow the tax increases to go into effect and then to cajole Congress into passing a few small tax measures to benefit select constituencies arguing that he is calling for tax cuts and that the Republicans are blocking them. But if taxes increase by 16 percent what will be the effect on the economy.
Unlike the Keynesians, I do not foresee this having as dramatic an effect as one would think. The tax hikes represent 2.6 percent of total GDP, and while government is a net extractor from production, the economy is growing at just about 2 percent per year, so even if these taxes were taken out of the economy and sent to Mars, the resulting recession would be slight.
If, on the other hand, spending is constrained by the $105 billion reduction in growth projected by the CBO, there could be beneficial effects on the overall federal deficit. This deficit is currently crowding out private sector borrowing and over the long term is a much larger fiscal problem than the so called cliff. Actual reductions in Federal spending and honest deficit reduction would keep a lid on interest rates when the economy starts to actually recover and effects of the Federal Reserve’s printing spree begin to show.
While I would never assume that Washington will do the right thing, it is possible that the government’s own ineptitude will end up working out for the better in the end, and that the current stalemate could lead to significant cuts in the deficit and a better economy in the future. Another recession may simply be the price that we have to pay for this.