The Coming Fiscal Bluffs

The “fiscal cliff” must be very confusing to most Americans. Largely ignored during the presidential campaign, it suddenly seems to be Washington’s sole focus. But know this: it is quite a problem.

In the absence of a new budget deal, a variety of temporary tax cuts will end beginning in 2013, as will a major spending program that extends unemployment insurance. The resulting higher taxes and reduced unemployment insurance will cut into people’s ability to spend. At the same time, Congress will be required to begin cutting government spending, thanks to the failure of the famous “supercommittee” to agree on a reduction of about $900 billion in federal spending over ten years. Half of the cuts will come from defense, Homeland Security and other security programs; the other half from social programs, excluding Medicare, Social Security and Medicaid. These cuts, too, will dampen the economy. (Indeed, every dollar of spending cuts does more damage than higher taxes, on balance.)

But why the sudden tension in the wake of the election, especially on Wall Street, where stock prices have fallen sharply? Because President Obama’s win makes an easy compromise less likely, if more sensible in its particulars than one Romney might have forged. 

Obama gave a brief talk about the fiscal cliff this afternoon. He looked more decisive and relaxed than he has in a long time, perhaps thanks to his electoral victory. He was adamant that he wants taxes raised for the rich—those who make more than $250,000, about 2 percent of Americans. This has long been the president’s line, of course.

The House Republicans, who are in the majority again, remain firm that they will not allow taxes to be raised for the rich, though they have made one mild concession: House speaker John Boehner has said he is willing to look at closing loopholes to raise tax revenues. This isn’t likely to provide a successful path to compromise, but it is at least a crack in the barrier.

So let’s say no agreement is reached before December 31. At that point, taxes will rise by about $450 billion. These tax increases include all the Bush tax cuts, about $190 billion worth. Of that, $56 billion will come from the rich. The 2 percentage-point payroll tax cut that Obama put in place in 2011, and that was extended into 2012, would also likely be allowed to expire, accounting for more than $100 billion in tax increases. Taxes would also be raised on those who pay the alternative minimum tax (which is in need of an updating). This would mean about $100 billion more in taxes next year. The extension of unemployment insurance would also end—there’s about $40 billion.

As for government spending, the scheduled cuts amount to only about $80 billion in 2013, according to Goldman Sachs.

Thus, without an agreement, up to $600 billion in spending power will be taken out of the economy, or 4 percent of GDP. That’s one big number. It would lead to outright recession and a jump in unemployment of well more than 1 percent, according to the Congressional Budget Office.

Such a recession could easily deepen, as recessions often do, its component parts feeding on each other—unemployment leading to less demand, less demand leading to less profit, and less profit leading to more job cuts. Unemployment could return to 10 percent. Given that Europe is already in a worsening recession, the risks are profoundly worrying.

Grounds do exist for compromise to reduce the potential $600 billion bite. Taxes for the other 98 percent will not be raised, and the alternative minimum tax increase could be eliminated, thus substantially reducing the tax increases. There would then only be a roughly $200 billion increase when payroll tax cuts expire and taxes on the well-off are raised. Modest new tax hikes are already built into the Affordable Care Act. Meantime, unemployment insurance could be extended, and only half of the automatic spending cuts could come into force.

These moves would reduce the consequences of the fiscal cliff by more than half, removing only $200 to $250 billion in spending power from the economy, as opposed to $600 billion. Catastrophe would be averted. But here is a key point: The removal of even 2 percent of GDP, though it would not lead to outright recession, would still mean slow growth. Add European unknowns to this, and we would have 8 percent unemployment to look forward to for a long time.

A further threat is that Obama will agree to cut Social Security and Medicare in order to convince Republicans to accept a tax hike on the 2 percent. For example, he could consent, disastrously, to raise the eligibility age of Medicare. Imagine trying to buy a health care policy at age sixty-six, while you’re retired?

Some bright Washington observers think Obama will hang much tougher, given his victory and the Democrats’ Senate gains. If so, he would be gambling that Republicans cannot tolerate a big tax increase or major cuts from the national-security budget.

But I don’t think Obama is that kind of gunslinger, even given his electoral advantage. He has shown himself to be open to cuts when it comes to entitlement programs, and he also wants to avoid panic in the financial markets, which could come about if the Republicans again go to the wire and refuse to raise the debt ceiling in early 2013.

Instead, Obama will again seek some kind of “bipartisan” solution, which may mean taking a bite out of Social Security and Medicare in return for a tax hike on the rich. Too bad. What we need is more stimulus, more public investment, and the maintenance of our cherished entitlements programs. It is hard to see those things happening next year.