The Problem
The fiscal cliff is similar to the idea of a snowball on a hill that builds volume over time and eventually turns into an avalanche. Because Congress and the president cannot agree on a long-term solution to reducing the federal budget deficit, expiring programs tend to be extended. The fiscal cliff is an unusually large number of contentious tax and spending laws set to expire December 31, 2012. These rules impact business as well as nearly every segment of the population^[1]. Collectively, the seven major initiatives amount to more than $600 billion, or about 4 percent of gross domestic product in calendar year 2013:

• The Bush Tax Cuts—These are a combination of 2001, 2003, and 2010 tax cuts that affect the top and bottom tax brackets; capital gains and dividend tax rates; the estate tax; the marriage penalty; and tax benefits for education, retirement savings, and low income families
• Payroll Taxes—Payroll taxes were cut 2 percent as stimulus in 2011 but were extended through the end of 2012
• Sequestration—The deal to get the debt ceiling raised last year set up a mechanism (called sequestration) whereby the Congressional Super Committee’s failure to agree on a $1.2 trillion spending cut plan triggers the reductions to be spread equally over 10 years, which goes into effect automatically. Half of the annual cuts come from defense budget authority and the other half are across-the-board reductions in nonessential discretionary spending
• Unemployment Benefits—The eligibility to receive emergency unemployment insurance benefits beyond 26 weeks was extended through the end of 2012
• Other Tax Provisions—Accelerated depreciation, the R&D tax credit, state and local sales tax deductions, and other tax code provisions will expire
• Alternative Minimum Tax (AMT) brackets—These are not automatically adjusted for inflation, so every year Congress patches the income trigger to prevent an additional 26 million tax filers from paying AMT^[2]
• The Doc Fix—This is an annual law to prevent a formula from reducing by about 30 percent the amount Medicare will reimburse physician services

The Warning
Business leaders, commentators, and economists are nearly unanimous in urging Congress to not wait until the last moment to avoid large, sudden changes to tax and spending policies at a time when economic growth prospects are fragile. Just the possibility of going over the fiscal cliff has a detrimental impact on business activity. A number of CEOs have gone public stating that just the uncertainty over the situation has caused their firms to delay investment projects and defer hiring^[3]. There is obviously anxiety among employees who work under federal contracts that would experience substantial cuts under sequestration. People who are worried about their jobs tend to restrict spending to only necessities.

The Consequences
Economic forecasters are in rare agreement that going over the fiscal cliff would lead to a recession in 2013. At 4 percent of GDP, the fiscal cliff is more than 2013’s expected 3.6 percent growth rate in current dollar GDP. Wells Fargo predicts that the combined effects of the tax increase and full-budget sequestration would be a decline in inflation-adjusted GDP in the first quarter of 2013 and a technical recession^[4] in the second half of the year that would yield no growth for all of 2013^[5]. The Congressional Budget Office predicts that the fiscal cliff would cause a recession in the first half of 2013 and the economy would eke out only 0.5 percent growth for the year as a whole. IHS Global Insight ran the fiscal cliff scenario through their macroeconomic model and forecasts a recession in the first three quarters of 2013 that would result in a 0.7 percent decline in GDP for the year. When the fiscal cliff scenario is compared with Global Insight’s baseline forecast for GDP growth (1.8 percent), the model predicts that the fiscal cliff would reduce economic activity by 2.5 percent in 2013.

The manufacturing sector would be disproportionately hurt in a fall from the fiscal cliff. Increased taxes reduce disposable personal income and lower consumer spending. Large cuts in federal government spending directly reduce economic output and spill over to cooperative programs with state and local governments. When firms see sales decline and experience reduced capacity utilization and falling profitability, it discourages business investment. IHS Global Insight’s baseline forecast calls for 2.5 percent growth in manufacturing production in 2013. Under the fiscal cliff scenario, manufacturing production would decline 0.5 percent. Therefore, going over the fiscal cliff would reduce manufacturing production by 3 percentage points.

The Solution
Washington politicians put partisanship before responsibility when it comes to resolving the divisive fiscal cliff issue. The pundits say that nothing will be done until after the November elections. In the lame duck session, Congress is expected to pass a continuing resolution that will keep current policies in place and push back the fiscal cliff deadline by several months. A lopsided political victory in November would give the winning party the votes to resolve the issue; otherwise, a compromise must be reached.

The reason that the country is currently in this quagmire is that not any solution will do. A continuing resolution that “kicks the can down the road” is a viable option in the short run but the long-term solution should not be to permanently incorporate an additional $600 billion into the federal deficit. The Committee for a Responsible Budget estimates that extending the fiscal cliff policies would increase the federal debt by about $7.5 trillion above current law by 2022—raising the federal debt-to-GDP ratio from 70 percent in 2012 to 88 percent in 10 years^[6]. The CBO states in its analysis that “eliminating or reducing the fiscal restraint scheduled to occur next year without imposing comparable restraint in future years would reduce output and income in the longer run relative to what would occur if the scheduled fiscal restraint remained in place.”^[7]

The lessons of the sovereign debt crisis in the Eurozone and past debt crises in other countries show that large budget deficits reduce national savings and eventually crowd out more productive private sector investment, lowering the pace of growth in future output and incomes. Moreover, the federal debt has to be financed. Chronic, large annual budget deficits eventually lead to an untenable situation in which the interest payments on the debt make up an ever-larger portion of the budget, requiring higher taxes and/or a reduction in government benefits or services.

Some hints on the solution to the fiscal cliff and the current large federal deficit are to have a plan that is gradual rather than abrupt and well thought out rather than sequestration. The across-the-board reduction for all nonessential discretionary spending and large defense cuts does not fix the long-term deficit because it does not touch the fundamental problem—untethered entitlement costs amid an aging population. For a credible solution to the federal tax versus spending imbalance, the Simpson-Bowles Commission plan^[8] is an excellent template.

Footnotes

^[1] Nigel Gault and Gregory Daco, U.S. Economy: The Fiscal Cliff, IHS Global Insight Analysis, June 28, 2012.

^[2]Between a Mountain of Debt and a Fiscal Cliff, The Committee for a Responsible Federal Budget, July 16, 2012, p. 3, http://crfb.org/document/between-mountain-debt-and-fiscal-cliff-finding-smart-path-forward.

^[3] Nelson D. Schwartz, “Fearing an Impasse in Congress, Industry Cuts Spending,” The New York Times, August 5, 2012, www.nytimes.com/2012/08/06/business/fear-of-fiscal-cliff-has-industry-pulling-back.html?pagewanted=all.

^[4] A technical recession is two consecutive quarters of declining inflation-adjusted GDP.

^[5] John Silvia, Michael A. Brown, and Sarah Watt, The Fiscal Cliff: Likelihood and Economic Impact, Wells Fargo Securities, Economics Group Special Commentary, June 20, 2012, https://www.wellsfargo.com/downloads/pdf/com/research/special_reports/TheFiscalCliff_06202012.pdf.

^[6]Between a Mountain of Debt and a Fiscal Cliff, The Committee for a Responsible Federal Budget, July 16, 2012, p. 3, http://crfb.org/document/between-mountain-debt-and-fiscal-cliff-finding-smart-path-forward.

^[7]Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013, Congressional Budget Office, May 22, 2012, www.cbo.gov/publication/43262.

^[8]The Moment of Truth, The National Commission on Fiscal Responsibility and Reform, December 2010, www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/TheMomentofTruth12_1_2010.pdf.