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Monday, September 24, 2012

The “Fiscal Cliff”: Macroeconomic Consequences of Tax Increases and Spending Cuts

Jane G. Gravelle
Senior Specialist in Economic Policy

A major policy concern for Congress is when and whether to address the “fiscal cliff,” a set of tax increases and spending cuts that would substantially reduce the deficit in 2013. In projections made in March 2012 by the Congressional Budget Office (CBO), this fiscal restraint, constituting 5.1% of output in 2013, would reduce growth to 0.5% from 4.4%. Unemployment would increase by 2 million. In August, updated estimates projected growth at a negative 0.5%.

Policy choices with respect to the fiscal cliff are difficult because of the conflict between shortrun and long-run economic and budgetary objectives. In the short run, the reduction in demand from the reduced budget deficits could damage an already fragile recovery. In the longer run, however, deficit reduction is needed to address a projected unsustainable debt level.

For FY2013, compared with FY2012, the policy-related fiscal cliff is $502 billion, 80% reflecting tax increases. There is an additional $105 billion from economic changes. The expiration of the 2001, 2003, and 2009 tax cuts (extended in 2010) and the expiration of the alternative minimum tax (AMT) “patch,” which indexes the AMT exemption for inflation, account for 44% of the policy-related fiscal cliff. Other tax provisions include expiration of the temporary two percentage-point reduction in the employee’s Social Security payroll tax (19%); the expiration of other tax cuts, including depreciation and the “extenders (13%); and taxes scheduled to come into effect as a part of health reform (4%). Spending reductions include the automatic spending cuts under the Budget Control Act (13%); the expiration of extended unemployment insurance benefits (5%); and the “doc fix” that will lower Medicare payments (2%). Most changes take effect after 2012, although the AMT and many of the extenders expired after 2011.

Legislative proposals up to this point have principally focused on extending the tax cuts. The Republican proposals (H.R. 8 and S. 3413) would extend the 2001 and 2003 Bush tax cuts for one year and the AMT patch for two years—45% of the policy-related cliff for FY2013. The Democrats’ proposal (S. 3412), a third of the cliff, would not extend the Bush tax cuts for higherincome individuals, would extend some small provisions from the 2009 stimulus, and would extend the AMT patch for one year. Both proposals would extend depreciation provisions for small businesses. The Senate Finance Committee has approved a separate bill (S. 3521) that includes a two-year AMT patch extension, small business depreciation, and the extenders.

CBO estimates are similar to those of other forecasters. Estimates are uncertain; CBO suggests a range of potential reductions in growth from 0.9% to 6.8% if the fiscal cliff occurs. Thus, the effects could be much smaller, but they could also be significantly larger, than CBO’s mid-point estimate. Different parts of the cliff have different effects per dollar of budgetary effects, with larger effects from the automatic budget cuts and ending extended unemployment benefits than from ending tax cuts for higher-income individuals. By one estimate, these two spending changes account for almost 20% of the cliff but 30% of the contraction. The so-called Bush tax cuts and the AMT patch account for 60% of the cliff and 50% of the contraction, whereas tax cuts for individuals with over $250,000 in income account for 11% of the cliff and 7% of the contraction.

If the only policy issue were the trade-off between short-run contraction and long-run budget reduction, allowing the tax cuts to expire and replacing them with robust spending and transfer policies might be appropriate. However, there are fundamental disagreements about the role of tax increases versus spending cuts in reducing the debt, which some maintain support a temporary extension of some or all of the tax cuts while these issues are sorted out.

Date of Report: September 20, 2012
Number of Pages: 22
Order Number: R42700
Price: $29.95

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