Everything you need to know about the fiscal cliff in one post

July 16, 2012

This morning, my colleague Lori Montgomery reported that Democrats are increasingly willing to allow the United States to fall off the so-called "fiscal cliff" at the end of this year  to get Republicans to agree to allow higher rates on wealthy taxpayers. Which raises the question — what the heck is the "fiscal cliff"?

What is it? How big is it?

The term is wonk-speak for a series of major policy changes that will happen automatically at the end of this year if Congress does nothing. The big players on the tax side are the Bush tax cuts and the payroll tax cut. On the spending side, the automatic cuts included in last summer's debt ceiling deal will take effect. But there's a lot more, as you can see in this table from the Committee for a Responsible Federal Budget:


Committee for a Responsible Federal Budget

The combined effect will be a huge fiscal contraction, one which, according to conventional economic theory, could pose a real threat to the economic recovery. Here's how the major provision break down by category, courtesy of the CBO:

By far the biggest provision is the Bush tax cuts, followed by the payroll tax cut and the cost of indexing the Alternative Minimum Tax (AMT) eligibility cutoff to inflation.

When will it happen?

The payroll tax break expires this December, and the Bush tax cuts expire Jan. 1, meaning that new, higher rates will take effect the following year. Since payroll taxes are deducted from wages every week, the effect there will be immediate, whereas the income tax rate increases only affect income starting in 2013. If employers adjust withholding, the effects could come sooner, but if there are logistical hurdles to that, the economic dent could be delayed.

The sequestration cuts will take effect starting in January too, meaning their impact, like the payroll tax cut's expiration, will be more immediate. The cuts are evenly split, with $27 billion each in 2013 for defense and non-defense spending, plus $12 billion in cuts to Medicare.

What will happen to the economy?

The CBO estimates that the total effect of these provisions is a 3.9 percent reduction in the growth rate of GDP next year — enough to make the year's total growth rate negative, plunging the country back into recession. What's more, the mere anticipation of this change will reduce GDP growth by 0.5 percent this year. However, this change is not evenly distributed between the cliff's components, as this helpful chart from the Committee for a Responsible Federal Budget shows:

So letting us fall over the fiscal cliff would be very bad in the short-term, and a deal that offset some of the changes would do a lot to mitigate that. The CBO estimates that if the payroll tax cut is allowed to expire but the other provisions are extended, growth will fall by 2.3 percent — not good, but it would leave the overall growth rate still positive.

Curiously, both deficit hawks and groups focused on promoting the interests of low-income people are more bullish about the cliff than the CBO is. The Center for Budget and Policy Priorities, for one, has noted that since most of the economic damage of the cliff is concentrated in the payroll tax cut expiring and the debt ceiling's cuts, letting the more expensive Bush tax cuts expire while extending those provisions would have a much lesser impact.

Some deficit hawks are also sanguine about the cliff. A report from the Carlyle Group argues that going over the cliff is actually preferable to extending these policies and increasing the long-term deficit. "This automatic deficit reduction package would largely solve near-to-medium term fiscal problems," the authors, Jason Thomas and David Marchick, argue. But it's worth noting that while the expiration of these provisions reduces the deficit, the effect on growth actually grows the deficit by $47 billion between 2012 and 2013. This is easily overwhelmed by the deficit reduction of the actual provisions, but it's a reminder that growth is an important and frequently undervalued tool for deficit reduction.

What could stop it?

The simplest way to prevent the fiscal cliff is simply to prevent any of its components from taking effect. But few want to do this. This would involve extending the Bush tax cuts again, which goes against Obama's deficit reduction plan, and extending payroll tax cuts that were supposed to be temporary. Democrats don't want to the former, and no one wants to do the latter indefinitely. So the likeliest deal would involve preventing most of the elements of the fiscal cliff from taking effect — such as by making the doc fix and AMT patch permanent — while limiting or eliminating the Bush and payroll tax provisions.

Here's my estimate of how a range of possible plans would affect growth, using the CBO's multipliers and the OMB's estimates of the cost of extending the middle-class provisions of the Bush tax cuts. I measured the impact if nothing changes, with and without the Bush tax cuts, with only the Bush tax cuts on middle-income people, and with and without the payroll tax cut:

All scenarios reduce growth, but removing all provisions except the Bush tax cut extension, and especially the Bush tax cut extension for high-income people, reduce it by a lot less.

There's also the possibility that the fiscal cliff will be averted by a "grand bargain" on the debt of the kind that was attempted last summer. A bipartisan group of senators ranging from Chris Coons to Mark Warner to Lamar Alexander to Tom Coburn has been meeting to try to hash out just such a deal. House Minority Whip Steny Hoyer's "go big" working group is focused on a similar solution, and Paul Ryan has touted his debt plan as a potential way to avoid the cliff. The idea is that by delaying some of the near-term contraction in favor of longer-run deficit reduction, we could get the best of both worlds: no recession in the near term, no debt crisis in the long-term. Such a deal could also include tax reform that cuts harmful tax expenditures. But as we've seen again and again, it's easier to talk about the possibility of such a deal than it is to get 60 senators and 218 representatives to go along with it.

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