The Fiscal Cliff Is an Exaggerated Crisis
The economy will not just immediately drop into recession on January 1
November 16, 2012
The story of the fiscal cliff is a simple one. The basic idea is that more than $500 billion in new taxes take effect on January 1, 2013. These include the end of the Bush tax cuts ($220 billion), the end of the payroll tax cuts ($130 billion), and the end of the Alternative Minimum Tax and others ($130 billion). There is also the sequester—or cutting—of $110 billion in defense and non-defense spending. Those who warn of a fiscal cliff say that when taxes rise and government spending falls at the end of the year, the economy will be pushed back into recession. The problem is, the last part of the story is not true. There is no looming crisis coming on January 1 if we do not act now.
Higher taxes and less spending would slow the economy if left in place over the next year and could possibly lead to another recession. But that recession will not happen on January 1. The sequester applies to appropriations that may not be spent for years. The higher taxes will not affect every single paycheck at once on New Year's Day. This recession story assumes these spending cuts and higher taxes remain in place all year and absolutely no one thinks that will be the case. If, instead, we reverse the tax increases and spending cuts 10 days after the start of the year, the economic impact will be minimal.
Interestingly, those who insist the loudest that we must act now, call for a "grand bargain" that would savage government spending, particularly Social Security and Medicare, in the name of reforming entitlements. They say it must be done because of our soaring deficits. However, the high deficits we see now are due to the recession. The budget deficit was actually only just over 1 percent of GDP in 2007 and was projected to remain near that level for several years before the Great Recession. There is no need to cut important social insurance programs right now that millions of Americans rely on and essentially voted to protect in November.
While long-term deficits are a concern, we don't have to act by January 1. By negotiating a smart budget in the next few months, the president and Congress are much more likely to arrive at an agreement that fosters growth and perhaps deals with long-term healthcare costs, the main driver of future deficits. But to act now by cutting spending on vital programs might be just the push our fragile economy does not need.