What is the fiscal cliff?
The fiscal cliff is an inapt metaphor for the looming consequences of some very bad congressional decisions.
On or around Jan. 1, about $500 billion in tax increases and $200 billion in spending cuts (see table 1) are scheduled to take effect. That's equal to about four percent of GDP, which is, according to the Congressional Budget Office, more than enough to throw us into a recession (more on that later).
Analysts disagree on exactly how quickly the recession would begin. That's why the "cliff" metaphor is inapt. If financial markets freak out, it might happen very quickly, proving the "cliff" imagery correct. But it might happen gradually, affirming those who've argued it's a "slope."
Either way, both parties agree it shouldn't be permitted to happen at all. But that's the rub. The reason that the fiscal cliff could push us into another recession in 2013 is because it enacts too much deficit reduction upfront, not too little. And yet, deficit reduction is something that most members of Congress support, at least in the abstract. So both sides want to replace the fiscal cliff with...something. The question is, with what?
What is the fiscal cliff in one sentence?
Much too much austerity, much too quickly.
If it’s not a cliff, what is it?
The term “fiscal cliff” comes from testimony Fed Chairman Ben Bernanke delivered before Congress earlier this year. But, as we mentioned, the "cliff" imagery has sparked some dissent. The Center on Budget and Policy Priorities thinks it's more of a "slope." The Economic Policy Institute calls it an "obstacle course."
We at Wonkblog call it the "austerity crisis." That solves two problems. First, the danger the economy faces is too much austerity too quickly, so swapping the term "fiscal" for the word "austerity" actually better reflects the situation. Second, while we don't know if it'll be a cliff or a slope, we do know that it will, if permitted to go on for long enough, be a "crisis." Thus, the "austerity crisis."
Five tax measures have provisions expiring at year’s end:
- 2001/2003 Bush tax cuts: These cut individual income tax rates, pared back the estate tax, lowered rates for investment income (such a capital gains and dividends) and expanded a number of tax credits, including the child tax credit. According to the Economic Policy Institute, these would cost $203 billion next year if extended.
- 2009 stimulus: This included expansions of the Earned Income Tax Credit, which provides aid to low-income workers, as well as the child credit, and the American Opportunity tax credit, which helps families pay for college tuition. Extending these would cost $10 billion next year.
- Payroll tax holiday: This was included in the December 2010 tax deal and slashed the payroll tax rate on employees from 6.2 percent to 4.2 percent. Extending it would cost $115 billion next year.
- Alternative Minimum Tax: Intended as a baseline tax for high earners, the AMT is not indexed for inflation and would hit a lot of middle-class taxpayers if not “patched” before next year. A patch would cost $114 billion.
- Extenders: This is the catch-all term tax wonks use for corporate tax breaks that need to be extended regularly. Doing that again, as per usual, would cost $109 billion.
- Spending cuts
Four types of spending cuts take effect next year:
- The sequester (or, as we sometimes like to call them, the big, dumb spending cuts that no one wants): Mandated by the Budget Control Act of 2011 (better known as the debt ceiling compromise), this institutes a 2 percent cut in physician and other providers’ Medicare payments, and a 7.6 to 9.6 percent across the board cut in all discretionary spending, except programs for low-income Americans. The cuts are evenly divided between defense and nondefense programs, with analysts predicting a crippling effect on all affected departments and agencies.
The sequester can be averted by repealing the portion of the BCA mandating the cuts, which amount to about $110 billion next year.
- Budget caps: Also in the Budget Control Act, these set a firm limit on discretionary spending within which policymakers must operate. They are set to reduce spending by $78 billion next year.
- Doc fix: This policy, passed every Congress for 15 years now but lapsing at the end of 2012, reverses temporarily cuts that Congress passed, and former President Bill Clinton signed, as a deficit reduction measure in 1997. The cuts, known as the “Sustainable Growth Rate” or SGR, require that growth in provider payments not exceed growth in Gross Domestic Product. If the doc fix is not extended, physician payments would fall by almost 30 percent, dwarfing the cuts enacting as part of the debt ceiling deal. That would cut spending by $14 billion next year.
- Unemployment insurance: Unemployment insurance was expanded following the recession, and due to the slow recovery this expansion has been regularly extended. Doing so again would cost $39 billion.
- Debt ceiling
When exactly the debt ceiling is next reached depends on how much the government actually spends and taxes in the coming months. But most analysts think the next debt-ceiling increase will come due around February. The Bipartisan Policy Center estimates we'll have to raise the debt limit by anywhere between $730 billion and $1.25 trillion to avoid the debt ceiling for all of 2013 (depending on whether the Dec. 31 fiscal changes measures are enacted or not) and between $1.3 trillion and $2.2 trillion in 2014.
A fiscal cliff deal is likely to include an increase to the debt limit. But in a world without a deal, an ongoing austerity crisis could be worsened by a default. The economic consequences of that are hard to even imagine
, but we’re talking about a crisis on the order of what we saw in 2008, at least.
What matters most in the fiscal cliff?
It’s important to recognize that the austerity crisis is a collision between deficit reduction and stimulus. The good news is that if you look at the various components of the fiscal cliff separately, you’ll see that the parts that do the most for deficit reduction do the least for the recovery, and vice versa. This suggests the possibility of “a la carte” approach to the fiscal cliff, in which we extend the most stimulative policies and wave goodbye to the most costly policies. And if you're looking to go a la carte then here, via the Economic Policy Institute, is the menu.
The most stimulative policies are, predictably enough, the policies that were intended to be stimulus. Among the least stimulative policies are the Bush tax cuts. The spending sequester is also a really nasty hit to the economy.
That menu, if anything, understates the cost of policies like the Bush tax cuts. Those numbers are only for 2013. The Bush tax cuts, if they’re extended, are likely to be extended at least for the next decade, which means their cost will be 10 times higher than what’s on the menu (actually, it’ll be even more than that because of inflation and economic growth, but let’s not get too complicated here).
What happens if we go over?
Analysts expect that the austerity crisis will weaken the economic recovery and quite possibly plunge the United States back into a recession. The CBO predicts that the U.S. economy will shrink by 0.5 percent in 2013, and unemployment will spike up to 9.1 percent from its current level of 7.9 percent, if no fix is passed. However, if all policies, including the payroll tax cut, are extended, the economy will grow 2.4 percent. Analysts at the Levy Economics Institute and Goldman Sachs have predicted even more dire outcomes.
If the austerity crisis hits in full, both short and medium-term deficit problems in the US would vanish. The CBO projects that under current law, debt held by the public will fall to only 58 percent of GDP by 2022, below the 60 percent mark that many economists warn against exceeding. By contrast, debt would climb to 90 percent of GDP if current policies continue, the highest point since after World War II. This graph, from the CBO, shows just how sharp the austerity would be.
The Tax Policy Center estimates that if we go over the fiscal cliff, the average American will see their tax bill rise by $3,446 in 2013.
That average obscures a bigger hit to the rich than the poor: Taxpayers making more than a million dollars will, on average, see a $254,000 tax hike, equal to about 11 percent of their income, while taxpayers making between $40,000 and $50,000 will see a $1,700 tax hike, equal to about 4.4 percent of their income.
Still, it’s a big hit to both groups, and that’s before you get into the effects of the spending cuts, which will hit the poor much harder than the rich.
How has Washington tried to solve the fiscal cliff in the past?
The Bush tax cuts were actually scheduled to expire in 2010: Republicans wanted to make them permanent during the original debates in 2001 and 2003, but for somewhat complex congressional reasons, their efforts to avoid a filibuster forced them to accept a 10-year expiration date.
In late 2010, both President Obama and Congress passed legislation extending the Bush tax cuts for two years, agreeing that the economy was too weak for a tax hike. The deal was also contingent on a two-year extension of federal unemployment benefits, which were included in the 2009 stimulus, a one-year payroll tax holiday to replace another tax break in the stimulus (later extended to two years), and the extension of a few other tax breaks from the stimulus. All of these provisions are due to expire at the end of this year, which is why they’re part of the austerity crisis now.
- Simpson/Bowles and Gang of Six
While they were still grappling with a foundering economy, leading Republicans and Democrats also became increasingly concerned about the growing deficit, which the financial crisis and recession significantly exacerbated. To that end, Obama created the Simpson-Bowles commission in 2010, whose members created a recommended framework for $4 trillion in deficit reduction. But the plan did not attract the required 14-vote supermajority to be sent to Congress. Later, a bipartisan group of senators known as the Gang of Six tried to build on Simpson-Bowles to formulate their own deficit reduction plan, but their effort, so far, hasn’t had any more luck.
In 2011, the new GOP-led House was demanding that the federal government reduce its deficit as a condition of raising the debt ceiling. Obama and Boehner tried to hammer out a deal, but the talks ultimately fell apart as Boehner rejected the president’s demand for more revenue.
Ultimately, to avert a debt-ceiling crisis, Congress and the White House passed legislation in August 2011 known as the Budget Control Act, which had nearly $1 trillion in upfront cuts and established a Congressional committee to come up with $1.2 trillion more in deficit reduction by late November 2011. If the supercommittee failed to agree upon a deal, the across-the-board cuts to both defense and non-defense spending—i.e. the sequester—would be automatically scheduled to take effect after Dec. 31.
The 12-member supercommitee deliberated through the fall of 2011, but ultimately failed to come to an agreement by the deadline. The main obstacle, once again, was revenue. Republicans rejected the Democrats’ proposed tax increases and Democrats spurned the Republicans’ revenue offers as too paltry. Even after the supercommittee failed, Congress could have independently passed a deal that reduced the deficit by $1.2 trillion to avoid the sequester cuts. But the 2012 campaign soon took precedence and both parties agreed that nothing would get done until after the election.
That’s why we’re now facing the sequester, on top of the Bush tax cuts and other provisions that were already scheduled to expire on Dec 31: They’re all policy decisions that Congress has made (or failed to make) over the past two years, piled onto a single deadline.
What do the parties agree on?
Both parties agree that doing nothing and letting all the scheduled tax hikes and spending cuts to take effect for all of 2013 would be a terrible thing for the economy, and something they want to avoid. No one likes the sequester’s indiscriminate, across-the-board cuts, and few want to raise taxes significantly on the middle-class.
However, while they oppose the fiscal cliff’s particular form and pace of deficit reduction, the leaders of both parties still want to enact major deficit reduction that brings down the longterm deficit. Both sides agree that such a deficit plan should include both tax revenues and entitlement cuts, generally speaking. And so the negotiations are, somewhat peculiarly, focused on replacing one deficit-reduction package with another deficit-reduction package.
What do they disagree on?
They don’t agree on taxes: Democrats want to hike taxes on the wealthy by about $1.6 trillion, and they want about $1 trillion of that to come from letting the top tax marginal tax rate snap back to its Clinton-era level of 39.6 percent. Republicans oppose tax increases in general and increases in marginal tax rates in particular.
The two parties also disagree about how and where to cut spending: Republicans want to make more dramatic reforms to Medicare, Medicaid, and other entitlement programs, as well as bigger cuts to domestic discretionary spending.
The earliest proposals have brought these differences into full relief: President Obama's opening bid calls for $1.6 trillion in tax increases and just $400 billion in spending cuts, in addition to $200 billion in new stimulus. By the White House's accounting, the whole plan would reduce the deficit by $2.4 trillion.
Speaker Boehner's counteroffer includes $800 billion in new tax revenue—without any rate increases—$900 billion in spending cuts from mandatory programs, $300 billion in discretionary cuts, and $200 billion in slowing the growth of Social Security benefits. Using the same accounting measures as the White House, it would reduce the deficit by $4.6 trillion.
The simplest option for Congress and the White House would be to do nothing. Taxes would go up. The military and domestic spending cuts in the sequester would bite down. This would be the single largest act of debt reduction in American history, cutting some $1.2 trillion from the deficit over the next two years. Trouble is, that much austerity would likely also induce a recession. That’s why few policymakers advocate this scenario.
There’s another problem with this plan: Lawmakers can’t just sit back and do absolutely nothing. Even if the tax hikes and spending cuts kick in, Congress would still need to vote to lift the $16.4 trillion debt ceiling by February or so. Otherwise, the United States government would no longer be able borrow money to fund its obligations. That could be trouble.
-Just go over and then make a deal
Another possibility is that lawmakers don’t reach a deal by Dec. 31. The United States goes over the fiscal cliff. But it’s only temporary. After all, those tax hikes and spending cuts don’t kick in with full force immediately. They’re spread out over two years. So there’s still time to make a deal when the new Congress convenes in January.
Why would lawmakers do this? It might make a deal easier. Right now, the two parties are having a tough time reaching an agreement because Democrats want higher taxes on the wealthy and Republicans mostly refuse to vote for any tax increases at all. But if we go over the cliff, taxes automatically go much, much higher than either party wants. Now the two parties simply need to debate how to cut taxes from this new baseline. That’s a happier discussion, in theory.
The downside is that Congress and the White House might not have much time to negotiate a deal in January or February before financial markets start nosediving.
There’s nothing stopping Congress and the White House from postponing the fiscal cliff until 2013 or 2014. Congress would simply vote to extend all (or some) of the Bush tax cuts and payroll tax cuts. Then Congress votes to override the sequester, so that none of the military and domestic spending cuts kick in. Suddenly, the fiscal cliff is gone--or at least pushed back.
The upside here is that there’s no recession. The economy gets time to mend. The flip side is that deficit would continue to grow--the CBO estimates U.S. debt would be $1.2 trillion higher over the next two years if Congress extends everything, compared with if we went over the cliff. Plus, we’d face another big showdown two years from now.
One alternative to extending the fiscal cliff that wouldn't require immediate deficit reduction, or the immediate formulation of a deal, would be to design a new trigger. There are several possible forms such a trigger might take, including cuts to tax expenditures, an increase in the capital gains tax, or more spending cuts.
Congress doesn’t need to make a big sweeping deal on the debt right now. It could do something smaller. One possibility being talked about is that Republicans would let the Bush tax cuts for income over $250,000 expire, as Obama wants. That would raise about $80 billion in 2013. In return, Democrats would find $80 billion in spending cuts. Then Congress extends (most) of the rest of the tax cuts.
That’s a small bit of austerity next year, but nothing like the full cliff. And lawmakers could continue working on bigger tax reform in 2013.
At the moment, there’s a lot of talk in Washington about a “grand bargain” between Republicans and Democrats. This would involve avoiding sharp austerity in 2013. It would also involve some mix of spending cuts and tax increases that are gradually phased in over the next decade, so as to slowly bring down the U.S. national debt. It would also include substantial changes to entitlement programs like Social Security, Medicare and Medicaid. Examples of a “grand bargain” framework include the Simpson-Bowles plan, or the Domenici-Rivlin plan.