Hey, I’m still just as sick of the “Fiscal Cliff/Slope” as I was before. The main reason of course, is that it was an unforced error beginning with its own creation, after the failure of the “Stupor Committee” around the Debt Ceiling increase. That whole saga (which could repeat itself in 2 months) was based on the Republican willingness, and even enthusiasm, to let the US government default on its debt for political reasons (something which would put the US in Argentinian territory). Anyway, the issue at hand is whether the Bush tax cuts are finally allowed to expire, whether a few annual ‘fixes’ are made to, for example, make up for the Alternative Minimum Tax threshold not being indexed to inflation, as well as make across the board cuts to government spending.
There are some political considerations that make one or the other thing more likely than another (here’s one suggestion of how it could go down and here’s a viewer’s guide to the negotiations), but the more interesting issue is the economics of the various aspects of the plan. I’ll break it into a few different components:
1) Taxes go up on the non-wealthy – It is pretty well accepted that higher taxes on the non-wealthy is not the best way to help the economy grow right now. However, the bulk of the discussion in Congress has omitted the most important contractionary tax rise that will kick in in 2013: the end of the payroll tax cut. The current tax cut reduces the payroll tax by 2% (from 6.2% to 4.2%, of taxes that are dedicated to funding Social Security, and are made up for by funds transferred in the budget so that Social Security remains funded at the 6.2% rate). Since payroll taxes are capped (you only pay Social Security tax on the first $110,100 of payroll income), the tax cut is targeted to the income groups where the stimulative impact is the greatest, because it goes to people in small amounts every other week, at payroll time, who are most likely to direct a big portion of that towards additional spending. As Krugman has reminded time and time again, your spending is my income, which is how the impact of the additional spending is higher than just the amount that everyone spends from the payroll tax cut (there is a ‘multiplier effect’). So, the discussion around the ‘fiscal cliff’ should focus more on stimulative issues, like extending unemployment insurance and the payroll tax cut.
2) Taxes go up on the wealthy – This is the biggest focus of the negotiations, as far as I can tell, with much of the debate going to the somewhat pointless argument of what the threshold is between someone being wealthy and not wealthy. That threshold is arbitrary, but even if it is set pretty low ($200,000 for example) it would only affect a small proportion of the population. According to IRS data, setting that threshold (according to data collected for 2009) would affect 7.8 million people, or just 5.6% of all the returns filed. Of course, it would be more likely to see a number somewhat higher, between $200,000 and $400,000, which will pretty dramatically reduce the number of people affected. So, we should not worry too much about the effect of taxes going up on the wealthy, simply for the reason that it will not have much of an effect because, well, because they’re wealthy (the higher taxes will have a limited impact on their spending, which will mean little contractionary impact on the economy as a whole).
3) Defense spending is cut – The reason I separate this out from the non-defense spending cuts is that there is a flavor of Republicans who want to cut government spending and claim it will not affect the economy, but who then warn that any cuts to defense spending will cripple the economy. Hypocritical? Yes. Opportunistic? For sure. The key thing to remember is that economics is not a morality play. The impact of government spending on the economy will be the same (more or less) whether you personally approve of that spending. Defense spending, non-defense spending, infrastruture improvements, whatever. More spending will move through the economy, building on itself through the multiplier and in a severe recession like we are seeing now, it will be supportive to economic growth. Cutting it severely before the recovery is strong enough to withstand the drag from the cuts is not smart, but for some reason people (Republicans) who hate the government want to pretend that since they don’t like government spending, cutting it will not act as a drag on the economy.
4) Non-defense spending is cut – As I said before, spending is spending is spending. And in a slow recovery, increased government spending will be supportive to the recovery and spending cuts will act as a headwind.
So, there you have it, my thoughts on the economic impact of the various parts of the ‘fiscal cliff’. Not the most scientific analysis, but that’s not really necessary since it is mostly a political exercise. It will have an impact on the economy, but not in the ‘cliff’ sense that if there is no deal on January 1, everything goes to hell. It is more analogous to going off a cliff with a hang-glider that has a motor that isn’t started now. There is a glide downward, but once the deal gets done (the motor turns on) most of the damage can be reversed unless it takes so long that you are already close to the ground, in which case you could crash and burn. But that’s months and months away, so if there’s a deal in the first couple months, no biggie.