Austerity, American-style, could send the U.S. economy tumbling next winter. But backing away from the brink could be dangerous, too.
To: President Obama, Members of the 112th Congress
Subject: About December
You may want to hold off on your post-election vacation planning. There isn't going to be much time to recharge before returning to work in Washington. No matter who wins the presidency in November, and no matter which party will control the House and the Senate next year, you -- the people currently in office -- will face a wave of difficult decisions in a lame duck session that is likely to be one of the most important in modern times.
Yes, the days of kicking the deficit can further down the road are over. You have reached a cul-de-sac. It's called Jan. 1, 2013.
Headlining the agenda will be what many, including Federal Reserve Chairman Ben Bernanke, are calling a "fiscal cliff" of tax increases and spending cuts. And the challenge is very serious. You, the 112th Congress, and you, President Obama, will need to reach agreement on a "grand bargain" to repair the nation's finances. You will need to craft a fiscal policy program that is not so austere in the near-term that it trips up an already fragile economic recovery, yet one that positions the country well for future growth by making substantial progress toward controlling the national debt. This means reaching bipartisan agreement on clear and credible long-term deficit reduction plans.
Why is it all so urgent? If compromise cannot be reached on changes in existing tax and spending policies, legislation that you approved earlier this year, and last year, and the year before will slam the brakes on the economy early in 2013. The nonpartisan Congressional Budget Office (CBO) estimates that under current law, if a scheduled expiration of tax provisions goes into effect this coming January, federal tax revenues will shoot up by more than 30 percent over the next two years. You simply can't remove that much potential spending power from the economy and expect business as usual.
The largest share of the revenue increase comes in 2013, when marginal income tax rates -- on everyone -- are set to rise as the Bush-era tax cuts expire. That will reduce disposable (after-tax) income by $160 billion during the year. And, unless you act before Jan. 1, millions of middle-income taxpayers will also become subject to the higher rates of the alternative minimum tax (AMT), adding an additional $125 billion to individual tax bills for 2012 due on April 15, 2013.
Together, those two tax increases will reduce disposable income by more than 2 percent.
Wait, there's more! Remember the temporary payroll tax cut you passed two years ago and then extended (twice) through the remainder of this year? It also expires on Jan. 1, slicing another $110 billion from disposable income in 2013.
Plus, provisions you enacted in 2010 as part of the Affordable Care Act (Obamacare) are set to raise the Medicare tax rate for high-income earners beginning Jan. 1. Next year's price tag: $46 billion.
Oh yeah, and there are about 80 other expanded credits and deductions set to expire, many of which you have been periodically extending for years, like the R&D credit. That's another $100 billion next year.
What about spending cuts? You bet, and they add to the economic drag. Remember the sequester provisions you agreed to last summer as part of an 11th-hour compromise to raise the statutory borrowing limit? You know, those automatic expenditure reductions put in place in case the congressional "super committee" failed to reach a long-term budget deal? Well, it failed, and the cuts to defense and domestic programs that are already scheduled (and in law) are set to reduce federal discretionary spending by $90 billion next year, beginning in January.
Oh, and emergency unemployment insurance disappears; that's another $35 billion hit to disposable income in 2013. And, the so-called Medicare doctors fix, which prevents Medicare payments to physicians from dropping by more than 27 percent, expires on, you guessed it, Jan. 1, 2013. That's $19 billion.
Add it all up and, unless you take action, an estimated $685 billion in combined tax increases and spending cuts will be trimmed from the economy in 2013. That's a big hit to a $16 trillion economy, especially one that's still weighed down by problems brought on by the financial crisis.
Such a fiscal shock would be double the size of any tax increase since World War II.
It would be larger than any fiscal stimulus ever passed.
The effect on discretionary spending would be like waking up on Jan. 1, 2013, to $10-per-gallon gasoline prices.
Happy New Year.
What would all that fiscal drag mean for economic growth in 2013? A major economic slowdown. Consumers would dip into savings to avoid having to cut spending by the entire amount. But if even one-third of the fiscal drag is offset with savings, that still reduces household spending by $450 billion in 2013.
That means the approaching fiscal cliff could reduce economic growth next year by 3 percentage points or more below what it would have been in the absence of the tax increases and spending cuts. Even a fast-growing economy would have difficulty absorbing such an event. It also leaves little-to-no cushion against unexpected shocks, such as a eurozone fracture or a saber-rattling incident in the Middle East. Under these circumstances, either could shove the U.S. economy into a new recession.
It's true that some forecasts are more optimistic, but they assume you reach agreement on a less austere fiscal policy for 2013. The CBO, on the other hand, has made a set of economic projections that highlights the consequences of going over the fiscal cliff. It forecasts a mild (two-quarter) recession and the nation's unemployment rate spiking back over 9 percent by the end of next year. Real GDP growth slows to just 0.5 percent in 2013.
Calling all compromisers
What about our federal deficit? Isn't that important? It sure is. That's what makes your job so difficult. The CBO estimates the deficit will break $1 trillion for the fourth consecutive year in 2012. During those four years, public debt as a share of the economy has more than doubled.
If you do nothing and all those expiring tax and spending provisions go into effect in January, the CBO believes revenues will rise, annual deficits will start to drop, and public debt will begin to retreat to more manageable levels in the coming decade.
Then again, you aren't likely to allow the country to go full speed over the fiscal cliff into recession. Recognizing this, the CBO has also produced an alternative outlook that assumes many of the expiring tax provisions are extended indefinitely this coming January and that scheduled spending cuts are waived. As you would expect, the economy grows noticeably faster in this scenario for a while, but there is a cost. That cost comes in the form of annual deficits that average more than $1 trillion a year in the coming decade, representing a substantial increase in the relative level of federal debt to the economy.
Such an increase in the debt will have significant implications for longer-term growth. All else equal, larger deficits will drive interest rates higher. As the recovery progresses, those higher interest rates will crowd out private sector investment. Economies with lower capital stocks produce fewer goods and services for a given number of workers. Indeed, the CBO projects that a decade from now real GDP could be 2 percent less than in its baseline. The gap grows indefinitely. In 25 years the economy is projected to be as much as 13 percent (about one-eighth) smaller than if the deficit is brought under control.
Difficult choices can no longer be deferred. Doing nothing is not an option. Reducing the federal budget deficit too quickly and significantly restraining the near-term recovery would be a mistake, but continuing to run high annual deficits threatens our prospects for long-term growth.
Sure, building a consensus and passing a long-term deficit reduction plan that does not harm short-term economic growth will be difficult. But it is not impossible. In fact, during a congressional hearing earlier this month Fed Chairman Bernanke reiterated that the two goals are in fact mutually reinforcing. A stronger near-term recovery will lower deficits in coming years, while a clear and credible plan that sets fiscal policy on a sustainable longer-term path will hold down borrowing costs and help improve confidence, allowing today's economy to grow faster.
A viable grand bargain combining longer-term deficit reduction and short-term stimulus is needed. Substantive compromise among a bipartisan assembly of leaders willing to reclaim the nation's future will be required. That means backing off of all-or-nothing tax and spending positions, putting everything on the table, and responding to this challenge with a tangible balance of entitlement spending savings and tax reforms sufficient to stabilize the debt. All of the leading nonpartisan or bipartisan proposals for comprehensive fiscal reform, including Bowles-Simpson, Domenici-Rivlin and the Senate "Gang of Six," share this basic judgment.
Treasury Secretary Timothy Geithner recently underscored how important the task facing you is, noting "this will be a big test to the capacity of this country to govern itself."
Oh, and have a nice summer.
Tom Stinson is a professor in the University of Minnesota's Applied Economics Department. He also serves as the Minnesota state economist. Matt Schoeppner is an economist for the state of Minnesota.