The "Fiscal Cliff"

What is the "fiscal cliff"?

The federal government spends more money than it takes in in revenue. That's the annual federal budget deficit. Each year in which that happens, the cumulative size of the federal debt goes up. The federal debt is money owed to the public: lenders who buy government bonds. The government has to regularly pay those lenders interest on the debt. The higher the federal debt, the more interest is owed in each fiscal year.

It's dangerous to let the debt get too large as a percentage of "the economy," a.k.a. the gross domestic product. GDP is a measure of the size of the economy. It aggregates the money value of everything that is produced in a given year.

As the ratio of federal debt to GDP goes up, there is increasing fear that the government will someday have to default on its regular interest payments due to not having enough money left over from other spending to cover the payments. So the interest rate on government bonds has to rise to induce the public to keep buying bonds, and the whole debt-to-GDP problem spirals out of control as the ballooning size of interest payments eventually eats up the entire federal budget.

According to "Choices for Deficit Reduction," a November 2012 report by the Congressional Budget Office, in the 2012 fiscal year the federal deficit will be $1.089 trillion. The federal debt at the end of 2012 will expand to $11,280 trillion, or 72.6 percent of GDP.

To rein in the deficit and blunt the debt threat, Congress passed a law, the Budget Control Act of 2011, that would cause federal taxes in several categories to rise in 2013. The tax hikes would by accompanied by across-the-board cuts in defense spending and in discretionary domestic spending. Here is a graph showing what would happen on January 1, 2013, if we go over the "fiscal cliff":

(Click to enlarge.)

This graph comes from The Washington Post. You can access it here. You can also just click on the graphic to enlarge it.

The related Post article says that the fiscal cliff is "a towering accumulation of $500 billion in budget cuts and expiring tax breaks that would abruptly reduce government borrowing but could trigger a new recession."

Note that there are three kinds of tax hikes in store if we go over the "fiscal cliff" in January:

1. The "tax holiday" that was instituted during the first Obama administration will end, and so payroll taxes will rise.
2. The "Bush era tax cuts" on personal incomes will expire.
3. "Tax extenders" such as the "patch" which keeps the Alternative Minimum Tax on personal income from kicking in at very moderate income levels will vanish.

There is also the threat of the looming "sequester," a feature of the "fiscal cliff" in which automatic across-the-board cuts in the Pentagon budget and in so-called discretionary domestic spending will kick in, reflecting the terms of the 2011 "debt-ceiling deal." In that deal, Congress and the president agreed to set up a committee to devise a fair and balanced plan to cut the deficit. If the committee failed to agree on a plan, the automatic sequester would instead arrive on January 1, 2013. Well, the committee failed to agree, and the fabled sequester now looms.

Mandatory spending on entitlements such as Medicare and Social Security was left alone by the Budget Control Act and the debt-ceiling deal.

If sequestration actually goes into effect on January 1, 2013, along with the various tax increases, the CBO projects that the fiscal 2013 deficit will drop to $641 billion. It would otherwise be $1.037 trillion if the automatic spending cuts and tax hikes of the "fiscal cliff" were not to go into effect.

But those arbitrary expenditure cuts and tax increases which make up the "fiscal cliff" would mean less money is spent by the government and by consumers on goods and services. GDP would shrink as businesses sell fewer products and have to lay off more workers. The economy would surely enter another recession.

Those arbitrary expenditure cuts and tax increases will indeed happen unless a "grand bargain" is agreed to between Congress and the president before the end of 2012.

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So we are between a rock and a hard place. If we don't tame the deficit and pare down the federal debt, we face the looming threat of federal insolvency. But if we let automatic across-the-board spending cuts and tax increases go into effect at the end of 2012, we'll drive the economy back into negative GDP growth with a concomitant rise in unemployment.

Meanwhile, pending the arrival of either the "fiscal cliff" or some sort of "grand bargain," businesses can't estimate how fast GDP is going to grow. Anticipated fast GDP growth might induce corporations and small businesses to spend more money to expand. They'd hire more employees, more people would receive regular paychecks, and so they'd spend more money. Businesses would sell more goods and services, and GDP would grow still faster.

But worry about the "fiscal cliff" keeps that virtuous circle from developing. Businesses generally need to wait to expand until they know what the federal government is going to do about the deficit and the debt. They expect looming tax hikes would adversely affect them, as small business income is taxed as personal income of business owners ... and as corporate taxes would go up as well. Government spending cuts would likewise hurt businesses, as aggregate demand for what they make or do is concomitantly reduced in quantity.

Barack Obama, as our newly re-elected Democratic president, has said he wants to work with Congress to figure out how to combine tax increases with spending cuts in a way that would avert the most disastrous effects of the "fiscal cliff." He wants to increase taxes on people with incomes over $250,000, while holding taxes steady on those with smaller incomes. For each dollar of increased tax revenue, he wants to find $2.50 in carefully designed spending cuts that would minimally impact ongoing federal responsibilities and the economy.

Speaker of the House John A. Boehner, an Ohio Republican who was also just re-elected, objects to any tax-rate increase for richer Americans. Instead, Boehner prefers to collect additional income tax by virtue of eliminating or limiting deductions which reduce tax filers' taxable incomes below their actual incomes. Those "loophole" reductions would ostensibly accomplish the goal of collecting more money from the well-to-do while not hurting the middle class. Boehner would complement that aspect of deficit reduction with his own selection of appropriate spending cuts.

But Democrats charge that eliminating or limiting such deductions as those for home mortgages and charitable contributions would unacceptably nick the middle class, and in any case could not bring in enough new revenue. The rich would not be required to pay their "fair share." The economic recovery would be set back because too many of the dollars not collected from the well-off would be saved by those wealthy folks, rather than shelled out for goods and services. Dollars left with the middle class, on the other hand, would tend to be spent right away on things that businesses make or do. So the preference of Boehner and the Republicans for loophole reductions rather than tax-rate hikes, the Democrats say, wouldn't be the best thing for the economy.

And, Democrats say, Boehner would need deeper spending cuts than he admits to needing, in order to achieve any given deficit reduction target. That would cut too much into the ability of the government to carry out the functions most Americans expect of it.

The CBO report says that leaving the 2011 Budget Control Act in place, without any "grand bargain" modification, which the CBO calls its "baseline" scenario — it is the scenario represented by actually going over the "fiscal cliff" — will indeed reduce the deficit exactly as advertised. By fiscal 2020 the deficit would drop from the current $1.089 trillion to just $142 billion, after having dropped as low as $79 billion in fiscal 2018.

Under the CBO's "alternative fiscal scenario" — in which current tax breaks get extended rather than expiring, and the other provisions of the 2011 Budget Control Act get set aside — the deficit would stay big, so that by fiscal 2020 it would be fully $1.102 trillion annually. The debt would balloon to $19,477 trillion — where under the baseline scenario it would be only $13,964 trillion, or just 61.4 percent of the estimated GDP at that time. Under the CBO's "alternative fiscal scenario," the debt-to-GDP ratio would bloat to fully 85.7 percent. Even worse, by 2037 the debt-to-GDP ratio would skyrocket such that the federal debt is (gasp!) 200 percent of GDP!

The CBO explores other deficit reduction schemes besides the "baseline" scenario in its report, and suggests that some of them would successfully pare down the deficit in much the same way as the baseline "fiscal cliff" scenario does, but with fewer negative side effects on the economy or on the level of government services. In other words, there is much room for a "grand bargain" to be struck.

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Yet the CBO also finds that the 800-lb. gorilla in the room is something the "baseline" or "fiscal cliff" scenario doesn't address: entitlements. The anticipated level of "benefits from Social Security and Medicare and long-term care services financed through Medicaid" are set to grow unsustainably, mainly due to a large rise in the cost of delivering health care:

(Click to enlarge.)

The growth in Social Security benefits between now and 2037 is meanwhile expected to be quite moderate as a percentage of GDP, and other noninterest spending as a percentage of GDP is expected to decline. But government health care expenditures as a percentage of GDP will rise from roughly five percent today to around 10 percent by 2037!

Of that rise, the lion's share is due to Medicare. An aging population is expected to demand correspondingly more health coverage under the Medicare program ... even as the cost of health care delivery continues on its present trajectory of swift growth.

The CBO report says, "Unless [major federal health care programs and Social Security] are changed, or the increased spending is accompanied by some combination of sufficiently lower spending on other programs and sufficiently higher revenues, deficits will be much larger in the future than they have tended to be in the past."

So merely finding a way to avoid going over the "fiscal cliff" is not enough. Congress and the president have to find a way to tame the growth of Medicare as well.

Stay tuned for more about the "fiscal cliff" ...