Unless something unexpected happens, the United States’many legislated reductions in taxes over the past 12 years – all of which havebeen explicitly temporary – will expire simultaneously at the start of 2013.American tax rates will revert overnight totheir Clinton-era levels.
Some of these reductions were implemented to fight what wasseen four years ago as a temporary downturn. Although their supporters wantedto make them permanent, claiming that they were temporary allowed for the circumvention of procedural requirements in thelegislative process that Democrats had created in a vain effort to guaranteefiscal sanity.
The immediate increase in tax rates is only part of thestory. At the same time, automatic reductions in the defense budget and“discretionary” domestic spending – agreed to by both Democrats and Republicansin the summer of 2011 – will take effect.
Couple these taxincreases and spending cuts with the provisions of “Obamacare,” the UShealth-care reform championed by President Barack Obama, and, as of January 1,2013, America’s  long-run structural budget deficit disappears. Therestored tax rates will, for the foreseeable future, be sufficient to supportthe US defense establishment, the growing US social-insurance system, and amoderate – albeit inadequate and suboptimal –amount of other “discretionary” federal spending. The US national debt/GDPratio will be on track to fall from its current level of 75% to 50% by 2035.Moreover, the US will begin running primary budget surpluses – the fiscalbalance minus interest payments on existing debt – by 2015.
So why isn’t the prospect of going over the fiscal cliffgreeted with enthusiasm? Yes, there will be big spending cuts – which will hitdefense contractors, doctors with Medicare patients, and all who benefit fromor rely on government discretionary spending – and substantial tax increases.But, to balance the budget in the long run, either taxes have to go up orspending has to go down relative to some baseline, or both.
There are two reasons why deficit hawksare not declaring victory. First, many who call themselves deficit hawks arereally spending hawks: they believe that US social insurance is too generous tothe unemployed, the disabled, the elderly, and the sick, and that by far thebest policy is to cut back on such programs rather than raise taxes to pay forthem. But, they fear that calling for spending cuts will be unpopular, unlike,they hope, demands to balance the budget. For them, the problem with the fiscalcliff is that it does not cut spending enough and raises taxes too much.
Second, and more important for those who worry about the USeconomy’s health, the process is not well-described by the term “fiscal cliff.”It is, rather, an austerity bomb that hits aneconomy in which unemployment remains high, the employment-to-population ratioremains horrifyingly low, and there are only feeblesigns that the large gap between current and potential output is closing.
The past two months’ run-upto the austerity bomb’s detonation has alreadyreduced projected real GDP growth in 2013 from 3% to 2.5%, and has raisedlikely end-2013 unemployment from 7.5% to 7.7%. Each day from January 1 to June30 that the damage continues will have a roughly linear impact on economicperformance in 2013, reducing the likely full-year real GDP growth rate by0.0084% – and only if a deal is ultimately reached that would have caused noeconomic harm in 2013 had it been reached on November 10, 2012. If no deal isreached by June 30, America’s likely 2013 real GDP growth rate will be -0.5%,with the likely unemployment rate returning to 8.9%.
Spending cuts and tax increases that in the long runrestore fiscal sanity and balance are good. Having them all hit a weak,still-depressed economy simultaneously is not good. Thus, US officials facefour tasks.
First, Republicans and Democrats must negotiate abipartisan agreement to stretch out the spendingcuts and tax increases that take effect on January 1, 2013. That way, they willaffect the economy gradually over five years, rather than all at once.
Second, the Federal Reserve should expand its quantitativeeasing and forward guidance programs. Consumers will be spending less in 2013,owing to higher taxes, as will government, which means that someone has to bespending more. Housing construction and exports are the obvious candidates, andboth can be boosted somewhat by more aggressive balance-sheet operations by theFed, together with promises of continued low nominal interest rates and higherinflation in the medium term.
Third, the large government-sponsored mortgage enterprises,Fannie Mae and Freddie Mac, should be used as macroeconomic-policy tools torestore housing construction to its long-term trend level. This should havebeen done five years ago, but better late than never.
Finally, and also five years too late, the US Treasurysecretary should announce that while the strong-dollar doctrine was appropriate(and in America’s interest) during the dot-com boom, the country needs a weakdollar in the aftermath of the austerity bomb’s detonation.
Reaching the wrong agreement to defusethe austerity bomb, or cushion the economy fromits impact, would merely recreate America’s long-run structural budget deficit– a very bad outcome. Failure to take all four steps outlined above all but guarantees renewed recession in America, evenif a good agreement is reached on stretching out the tax hikes and spendingcuts. And if no agreement is reached on that, undertaking the last three stepswould at least reduce somewhat the subsequentdamage.