How ‘Taxmageddon’ would affect the U.S. economy

What will the economy look like in 2013? A great deal depends on what Congress decides to do at the end of this year. Remember, the Bush tax cuts are expiring, the payroll tax holiday will sunset, and a bunch of new spending cuts under the debt-deal “sequester” are scheduled to kick in. Coming all at once, that’s a potentially big drag on growth.

Jared Bernstein passes along a chart from Goldman Sachs that tries to map out a couple of different scenarios here. The dotted line shows what could happen if Congress can’t reach an agreement and lets all tax cuts expire and spending cuts kick in. If that happened, the U.S. economy would grow at least 3 percentage points less than its potential for each of the first three quarters of 2013:

To put this in perspective, the Federal Reserve expects the economy to grow at a roughly 2.9 percent pace in 2013. If Congress does nothing at the end of this year, much of that growth could be wiped out, and there’s a strong possibility that the United States could lurch back into recession. (Granted, a lot could depend on how the Fed reacts in this situation.)

On the flip side, as Ezra discussed in Thursday’s Wonkbook, letting all of the tax cuts expire and spending cuts kick in would also cut the U.S. deficit considerably: “Public debt falls from 75.8 percent in 2013 to 61.3 percent in 2022.”

Meanwhile, note that, according to the Goldman Sachs chart, fiscal policy will likely be holding back the economy a bit in 2013 no matter what Congress does. The stimulus is finally winding down and overall government spending is expected to shrink next year (pdf), thanks to tighter budgets. There's a baseline austerity built into the budget that will subtract roughly 1 percentage point of GDP growth next year, even if Congress extends all the Bush tax cuts and avoids the sequester.

Indeed, this drag has been going on for some time, and it may help explain why the recovery has been so anemic. By contrast, during Ronald Reagan’s first term, when the economy was hauling itself out of the 1982 recession, federal and state governments were expanding and helping to boost GDP growth. Now, the opposite’s happening. As Jared Bernstein puts it, “We’re actively applying leeches.” The only real question is how big the leeches are going to be.

For more on Congress’ end-of-the-year choices, the Committee for a Responsible Federal Budget has a note on the “economics of the fiscal cliff.” They note, among other things, that the spending cuts from the sequester would actually have the biggest impact on growth in 2013, even though they’re smaller in dollar terms than the Bush tax cuts.

Related: ‘Taxmageddon’ in one table.