Some Thoughts on the Fiscal Cliff Deal

As expected, Congress and the President reached a deal avoiding the worst of the fiscal cliff.  I won't get into the politics of the deal, but it's surprising that there were virtually no net reductions in spending as part of the deal ($15 billion over 10 years).  The response of both sides is that spending reductions will take place later, when there's no rush to meet a deadline.  Perhaps.  We'll find out soon as the next debate over the budget will take place in February as the US must raise the debt ceiling.

How does this affect the national debt over time?  It has some impact, but clearly falls considerably short of what's necessary and doesn't address the primary issue - increases in entitlement spending, particularly Medicare and Medicaid.  Any serious attempt to address future deficits and the national debt must reduce the growth of entitlements.  For more details, see my my earlier post on the fiscal cliff.

Back to the economics.  The good news is that the US didn't go off the fiscal cliff.  Also, the tax increases shouldn't cause much harm to the economy over time.  The tax on dividends and capital gains for upper-income earners rises to 20% from 15% and income tax rates rose modestly for the highest income earners.  One can argue that this is not the best policy, but it's hard to argue that this will result in significant harm to long-term economic growth.  In the near term, the increase in the payroll tax will be a drag on economic growth.  All working Americans will experienced a 2% cut in after-tax pay (for wages and salaries up to just over $110,000).  Clearly this will lead to some combination of less consumer spending and less personal savings.  On the flip sides, the fiscal cliff deal removes a lot of uncertainty about the tax code, which may help free up some spending.  Overall, the deal will be a drag on economic growth for the first half of 2013.  Given the economic weakness of the economy at the end of 2012 (weaker than expected Christmas sales along with an undesired buildup in inventories), economic growth should be quite weak as we begin the new year.

For more specifics, please check out my other website for various economic forecasts.

Fiscal Cliff: Looking at some numbers

As we get closer to the fiscal cliff, I thought it would be helpful to consider different ways that the government can reduce future deficits and debt.  Here are some numbers that I shared with my classes a few weeks ago.  As noted, this is not my proposal (though I support some of the items).  Instead, it provides some context for what needs to be done to contain the national debt.  All numbers reflect 10-year esimates by the Congressional Budget Office.

 

 

Program	10-year savings
change the cost-of-living adjustment for government pensions (including military)	$24 billion
change the cost-of-living adjustment for Social Security	$112 billion
raise age for Medicare eligibility to coincide with Social Security	$125 billion
raise the early retirement age for Social Security (full retirement is being raised by 2 years, this would raise early retirement also by 2 years; phased in over time)	$144 billion
reduce the growth rate of non-defense discretionary spending by 1% annually	$327 billion
reduce the growth rate of defense spending by 1% annually	$286 billion
cap tax deductions at $50,000	$749 billion
raise top tax rate by 1%	$84 billion
change the inflation rate used for indexing various parts of the tax code	$72 billion
raise gas tax by 10 cents per gallon	$175 billion
total (not including savings on interest)	$2.1 trillion

Fiscal Cliff - The Big Picture

What combination of tax increases and spending cuts should be used to reduce the deficit?  Who should make sacrifices?  Do we need to make significant reductions in the deficit right away or over time?  While it's tempting to get bogged down in the details, it's important to step back and see the big picture. The fiscal cliff came about over concerns about the budget deficit and national debt. However, from an economic point of view, the goal is not to balance the budget and/or reduce the national debt. Instead, the goal is to try to achieve strong and sustainable economic growth over time (which should increase the average standard of living and thus improve the lives of people). High deficits and debt are a threat to sustainable economic growth, whether through crowding out of investment (i.e., making it more difficult for business to purchase necessary equipment, structures, etc), crowding out of government programs or tax reductions (due to having the pay more interest on a growing debt), or risking a sovereign debt crisis. Thus, any policy designed to control the budget deficit should take into account how it affects economic growth over time.

Policies to reduce the budget deficit are likely to reduce economic growth in the near term, thus most economists suggest an approach that has a small effect initially, but is generally seen as resulting in significant deficit reduction over time. To summarize, the following are generally agreed to be elements of a successful package:

• credible deficit reduction plan that has a larger impact in the medium to long run
• does little harm or promotes long-run economic growth (i.e., does not discourage increases in human capital, physical capital, or technological development)
• accounts for non-economic values (people may differ on these; they may include phasing in changes to programs like Social Security, Medicare, etc., since current retirees and those approaching retirement made plans based on the current system; also, there are issues of efficiency vs. equity, ...)

What changes need to be made?  Given the results of the 2012 election, it is generally agreed that increasing tax revenue will be part of any deal. In a previous post, I discussed one proposal to limit the amount of deductions to $50,000, that is estimated to be able to raise more than $700 billion over ten years, 80% of which comes from the top 1%.  On the spending side, virtually all budget experts and economists recognize the need to reduce the growth of spending on entitlements, since that's the fastest growing part of the budget (note: though the graphic below is from the Heritage Foundation, a conservative organization, the underlying data is from the Congressional Budget Office and President Obama's Office of Management and Budget).



Other programs can be changed as well, but tax changes and reducing the growth of entitlement spending are essential components of any credible deficit reduction plan. The question remains, will there be the political courage to make the tough decisions and the necessary compromises?

Resources for Understanding the Fiscal Cliff

Given all the discussion about the Fiscal Cliff, it's important to understand what it is, how we got here, and why it's a problem.  As a reminder, the Fiscal Cliff involves the simultanteous expiration of the Bush tax cuts, the payroll tax cut, and mandatory cuts in defense and discretionary program beginning in January 2013.  What in the world does that mean?  The following are some useful resources for understanding the Fiscal Cliff.

• Video about the fiscal cliff (from the Wall Street Journal)
• The Fiscal Cliff: A Primer (Tax Foundation)
• Expiration of the Bush Tax Cuts
  • What are the Bush tax cuts?
  • What about me? A tax calculator that shows the impact of the expiration of tax cuts.
• How we got to this point (Pete Peterson Foundation) - analysis of budget agreement that raised the debt ceiling in Aug 2011
• Sequestration: over $100 billion in spending cuts in 2013 - half in defense, half in other discretionary programs (not entitlements)
• Expiration of payroll tax cut (2% tax cut that was part of the stimulus in 2011 and 2012)
• Impact on the economy
  • CBO blog post summarizing the economic effects of the fiscal cliff
  • The Economic Impact of the Fiscal Cliff: An Update (Wells Fargo)
• Fix the Debt: a bipartisan organization designed to educate the public about the debt problem as well as to promote a credible plan to contain the growth of the national debt

In future posts, I'll discuss specific aspects of the Fiscal Cliff including the big picture as well as details as to what's involved, the current status, and the likely impact.

Taxes and the Fiscal Cliff

I'm planning a series of posts regarding the fiscal cliff, but Greg Mankiw recently posted a link to a study by the Tax Policy Center (joint project of the Urban Institute and Brookings Institution; both normally condiered center-left institutions) which examined the impact of limiting tax deductions.  For those who listened to the campaign closely, this was part of Mitt Romney's tax reform proposal (lower the tax rates and limit the deductions; he mentioned figures between $17,000 and $25,000).  For new readers of this blog, lower tax rates provide for a higher after-tax rate of return on working, investing, and saving, thus leading to more of each (how much of an impact is subject to some debate).  Given that Mitt Romeny lost, his tax reform proposal won't be implemented, but instead of allowing the Bush tax cuts to expire on those earning above $250,000 per year, taxes can be raised by limiting tax deductions.  One of the chief proponents of this approach is Martin Feldstein, chair of the Council of Economic Advisots for President Reagan.  He, and many other economists, refer to most tax deductions as tax expenditures.  Why?  the government can subsidize a certain activity by spending money on it or by allowing individuals to deduct it from their taxes (here are commentaries from Feldstein in the WSJ and NY Times).  So there's some agreement between those on the right and left about reducing tax expenditures (limiting tax deductions) as a way of achieving more government revenue.  According to the study, limiting tax deductions to $50,000 per year would raise over $700 billion over the next decade with 80% being paid by the top 1% (this assumes the Bush tax cuts are extended for all income levels, including those earning over $250,000).  Thus, President Obama could get his tax hike on the rich while Republicans can extends the Bush tax cuts and keep tax rates at their current level.