The ‘fiscal cliff’ deal could hurt the economy

December 18, 2012

Now that’s what a negotiation looks like.

Up to this point, the talks between the White House and Congressional Republicans over resolving the "fiscal cliff" have been — as far as the public could see, anyway -- exercises in strategic bluster. But now there seems to be a genuine give and take: Both sides are making offers that concede that they will not get their way on everything. There are still no guarantees of a deal by the Jan. 1 onset of the austerity crisis. But there is enough on the table now that we can start examining what it would mean for the economy in 2013 and beyond.


House Speaker John Boehner at the White House for fiscal cliff negotiations. (Chip Somodevilla -- Getty Images)

In a nutshell it’s this: There should be an immediate boost to the economy from taking the fiscal cliff off the table; uncertain effects from a deficit-reduction plan could possibly raise business confidence; expected tax hikes on the affluent would be a mild negative; and the expiration of the payroll tax holiday would be a significant negative.

In the very short run, a deal — almost any deal — is clearly positive for the economy. Corporate executives describe a fearful environment among their customers that the United States could go over the fiscal cliff and face a recession in early 2013. Simply taking that possibility off the table could not only improve business confidence but also spark a catchup effect as capital spending and hiring that companies would have done in the final months of 2012 would start up in 2013 instead.

“Certainty is good,” Jeffrey Immelt, the chief executive of General Electric, told analysts Monday in a presentation. “There was definitely less investment in the fourth quarter of the year, and if you have more certainty then you’re going to get more investment in 2013 versus 2012.”

But after any initial bounce to the economy, there's a tougher matter to predict: what a budget agreement will mean for the U.S. economy for the slightly longer term, the full year in 2013 and beyond.

Here, there are two competing forces. On the positive side, a sense that the United States is grappling with its longer-term deficits and debt problem could inspire businesses to hire and consumers to open their wallets, contributing to growth. On the other hand, the onset of austerity — not the austerity crisis, but just a down payment on deficit reduction of the sort at play in the negotiations — would sap economic activity now.

The question, then, is how powerful each of these forces is.

Estimating how deficit reduction's effect on confidence could help economic growth is purely guesswork. Normally, lower deficits would mean more private investment. But with the Federal Reserve keeping interest rates ultra-low and companies sitting on hordes of cash right now, it is hard to argue that business investment is being held back as  government borrowing crowds it out. The British experience with reducing deficits — it began austerity in 2010, and its economy has essentially flatlined since then — doesn’t inspire great confidence.

Then there are the more direct, easier-to-measure effects from austerity: Every extra dollar of taxes that the government collects is a dollar that Americans can’t spend; every dollar in spending that is cut, whether for defense or social welfare, lowers demand for goods and services in an already weak economy.

But not all austerity is created equal. By the reckoning of the Congressional Budget Office and many private analysts, tax increases on upper-income brackets are not likely to have a huge impact on the economy in the near term; the affluent are less likely than the middle class or poor to need to spend a given dollar of tax savings and therefore circulate money through the economy. The Obama administration has pushed to raise rates on the affluent both for ideological reasons and because they view it is a form of deficit reduction that will do less damage to the recovery than other tax proposals.

CBO estimates that the drag on economic growth from increasing taxes to Clinton-era levels only for households making over $250,000 would shave one-tenth a percentage point from economic growth and around 200,000 jobs by the end of 2013. And the actual damage to the economy in 2013 after raising taxes on the affluent is likely to be even smaller. Obama has conceded in his latest offer to making $400,000 the cutoff for income tax hikes  (House Speaker John Boehner wants the cutoff to be $1 million; one can imagine about 600,000 possible compromises). Either way, the tax increase would hit fewer people than if it applied to households with income over $250,000.

The same cannot be said of another proposal that is reportedly very much on the table in the negotiations. Two years ago, the government enacted a temporary cut in payroll taxes to help workers during the economic downtown. Now it appears that the tax cut won't be extended. That alone will reduce the take-home pay of a typical American worker by about $1,000. J.P. Morgan economists estimate the expiration of the payroll tax holiday would put a 0.6 percentage point drag on GDP. CBO's numbers bundle the payroll tax cut and extended insurance benefits together, and get a cost of 0.7 percentage points of growth and 800,000 jobs. In an economy that has been growing only around 2 percent a year, those numbers could have a significant effect on the recovery.

The talks reportedly also include stimulus that are more palatable to Republicans than  the payroll tax holiday, such as infrastructure spending. We'll have to wait for the details before judging how much those policies might benefit growth, and offset some of the damage from raising payroll taxes.

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Dylan Matthews · December 18, 2012