Fiscal cliff overhangs financial abyss
The presidential election is over, and Congress and national focus returns to the problem of the fiscal cliff — money to be sucked out of the American economy by delayed tax increases and spending cuts.
Unwilling to accept the discipline of its debt ceiling, Congress last year postponed decisions to cut spending by agreeing to delayed but mandatory cuts for January 2013.
Most members of Congress acknowledge that increased discipline must be applied to government spending. The divisive questions are where and how to cut spending. An International Monetary Fund study has renewed questions about the desirability of spending cuts as the Congressional Budget Office predicts another recession looming next year. This promises to intensify the debate.
The main items of the fiscal cliff alone total about $649 billion, or 4 percent of the nation's gross domestic product. GDP represents America's total economy.
The so-called Bush tax cuts are the largest single element in the fiscal cliff. Abolishing them would result in a tax increase of some $265 billion, of which some $210 billion would fall on middle-income and poor taxpayers, and the remaining $55 billion would fall on those with annual incomes above $250,000. This alone equates to more than 1 percent of GDP.
Abolition of the “temporary” stimulus of a 2 percent Social Security payroll tax break and the extension of unemployment benefits would impose a total added burden of some $140 billion.
Before the nation's attention was diverted by the election and Hurricane Sandy, eyes and minds focused on proposed cuts in congressional spending that totaled $160 billion, including about $100 billion in defense.
These items threaten to withdraw $590 billion from the economy. Negotiations likely will lessen this total. For example, if the temporary Alternative Minimum Tax were abolished, aggregate taxes would be cut by some $100 billion.
Minds likely will be focused most intensely by the IMF study published last month by Olivier Blanchard and Daniel Leigh concerning the “fiscal multiplier,” the amount by which the GDP is affected by a given cut in government spending as a percentage of GDP.
For example, a fiscal multiplier of 1.0 indicates that a cut in spending equal to 1 percent of GDP will cut actual GDP by 1 percent. If the fiscal modifier is 0.5 percent, a 1 percent cut will reduce actual GDP by only 0.5 percent.
University of Maryland professor Carlos Vegh suggests evidence that fiscal multipliers differ between economies. The level depends on the degree to which an economy has become reliant on government spending.
U.S. government spending has increased as a percentage of the economy. If the fiscal multiplier has increased to above 1 percent, a combined tax increase and spending cut of 4 percent could decrease America's GDP by more than 4 percent.
Having shirked action in good times, Congress faces anemic GDP growth of 2 percent. Scaling a 4 percent fiscal cliff while avoiding recession presents a monumental challenge.
John Browne, a former member of Britain's Parliament, is a financial and economics columnist for Trib Total Media. Email him at email@example.com.