Economists and politicians have been wringing their hands for months about the impending “fiscal cliff” that will occur on January 1 when a number of temporary tax cuts expire and large automatic spending cuts take effect. On Wednesday, Federal Reserve Chairman Ben Bernanke expressed concern that so much fiscal tightening at once will slow the economy further from an already anemic growth rate.
The Congressional Budget Office projects that the gross amount of fiscal tightening next year will be $607 billion, reducing the federal budget deficit from $1.2 trillion this year to $600 billion in fiscal year 2013. That’s equal to almost 4 percent of the gross domestic product. CBO estimates that reducing the deficit so quickly will reduce growth next year from 4.4 percent to just 0.5 percent.
Members of both parties are deeply concerned not only about the aggregate economic effects of the fiscal cliff, but also about its particulars. Democrats warn that much of the fiscal tightening will devastate the poor.
Republicans are concerned about the large cut in defense spending that will occur due to a “sequestration” that they agreed to in the Budget Control Act of 2011 in return for raising the federal debt limit. Under current law, total spending will be cut by $1.2 trillion between 2013 and 2021, divided equally between domestic and military programs. Not only do they oppose any cut in defense spending, but their presidential nominee, Mitt Romney, has promised a very substantial increase in such spending.
For years, Republicans have said that the deficit is horrendous, but must only be reduced by cutting spending. Moreover, they often assert that spending cuts will actually stimulate economic growth because government will be preempting fewer private sector resources. Republicans argue that the negative economic effects of the fiscal cliff come entirely from raising taxes, especially those on the rich.
Under current law, the top statutory income tax rate will rise to 39.6 percent from 35 percent, the tax rate on stock dividends will also rise to 39.6 percent from 15 percent, and the capital gains tax will rise to 20 percent from 15 percent. A number of tax cuts affecting the middle class will also expire.
Democrats say that having tax rates go back to the same levels they were under President Clinton will have only minor economic consequences and are needed both to reduce the deficit and because raising taxes on the wealthy is the only way for them to share in the fiscal belt-tightening. They support continuing tax cuts for the middle class.
At the same time, both parties agree that it is essential for the tax code to be reformed. Some have suggested that any extension of expiring tax cuts be temporary and tied to firm action on tax reform by the end of next year. The problem with this theory is that it is too easy to just extend the tax cuts again next year as was already done once in 2010.
At that time, President Obama said, as he continues to say, that the tax cuts should only be extended for those with incomes below $250,000. This would have required Republicans to act positively to enact legislation that would do so. There was no possibility of that and they simply waited for Obama to cave and extend all the tax cuts, which he did.
I don’t think there is any question that Republicans plan the same maneuver this year. They will refuse to act on any tax bill except one that simply extends all the tax cuts for yet another year. From now until the election they will do their best to get Obama to commit to a full tax cut extension by raising fears about the fiscal cliff.
Obama’s economic advisers hope that he will keep his options open and not commit to anything before the election. However, they are fearful that his political advisers will tell him he must promise to delay the impact of all the programmed spending cuts and tax increases lest he lose the election.
There are two good reasons for Obama to hold fast and not be bullied into making premature promises about what he will or won’t do regarding the fiscal cliff.
First, I believe that the economic concerns are grossly exaggerated. At least on the tax side, the impact will be minimal. The reason I say so is that the negative economic effects of the expiration of the tax cuts must, logically, be symmetrical to the positive effects of their enactment. Since there is no evidence that any of the tax cuts of either the George W. Bush or Obama administrations stimulated growth, there cannot be any negative effects from allowing them to expire.
Moreover, there is historical evidence from 1982 and 1993, when large tax increases were enacted, that they can in fact have stimulative effects. The economy soared after both tax increases went into effect. One reason is that the decline in the deficit had positive economic effects.
More importantly, no one believes that all of the tax increases and spending cuts will actually take effect. Some substantial part of the fiscal tightening will be offset either by delaying the day of reckoning or substituting other policies that will prevent a sharp fiscal tightening from taking effect.
This brings me to the second reason why Obama should avoid committing himself to anything before the election—it will change the political dynamics of the inevitable post-election negotiations.
As Obama’s former budget director Peter Orszag explained in a recent article, there is a huge difference in negotiating to prevent something from happening and fixing it after it has already occurred. If Obama wants Republicans to accept his priorities before the end of the year, he must force them to act. As noted earlier, they have little incentive to do so, believing that he will cave again as he did in 2010.
But what if Obama holds fast and lets the tax cuts expire? Orszag says he could propose new tax legislation and promise to veto anything Congress sends him that doesn’t closely adhere to its outlines. Suddenly the shoe is on the other foot and Republicans are the ones who will be forced to deal with Obama’s veto pen, giving him the stronger hand. Even if he loses the election, the position of congressional Democrats would be greatly strengthened, leading to a similar outcome.
If I were advising the president, I would tell him to have his staff prepare a complete and permanent replacement for all of the spending cuts and tax increases scheduled under current law. That legislation should be sent to Capitol Hill the day after the election, win or lose. Then he should hold firm and not waver. The sooner congressional Republicans accept that he means it, the sooner they will negotiate in good faith and support a permanent tax and budgetary fix.