On edge

Tax increases and spending cuts set to take effect Jan. 1, 2013, would likely push the U.S. economy back into recession, says William Branch, associate professor of economics at UC Irvine.

An expert in macroeconomics, he explains what the looming “fiscal cliff” – a term coined by Federal Reserve Chairman Ben Bernanke – would mean for the average American and what it will take from a polarized Congress to avoid it.

Q. What is the fiscal cliff, and what might happen to the U.S. economy if we go over it?

A. The fiscal cliff is a sharp tightening of financial policy that, based on current federal law, will take effect at the beginning of 2013. The Congressional Budget Office estimates that these tax increases and spending cuts will trim the national budget deficit by about 43 percent over the fiscal year. The federal government does not typically change its fiscal policy in such a short time span.

This cliff is a concern because it could potentially damage the country’s economic recovery. After the collapse of the housing bubble, the U.S. experienced a financial meltdown and recession that constituted the most severe economic crisis since the Great Depression. The recovery from that has been considerably slower than normal.

More worrisome is the fragile nature of the recovery, with the past few years being a series of fits and starts. Policymakers have been concerned about anything that might derail that growth, and an extreme fiscal contraction could be such a factor. The combination of higher taxes and less government spending will lead to less demand for goods and services.

The CBO estimates that the effect of the fiscal cliff will be to shrink real GDP [gross domestic product, a measure of economic activity] by 0.5 percent and put the economy back into recession.

Q. How did we get to this brink?

A. To answer this, it’s important to separate politics from long-term trends in the federal budget. Most economists agree that the federal budget is on an unsustainable pace. Regardless of the fiscal cliff, the combination of an aging population and growing entitlement programs (e.g., Medicare, Social Security) will lead to greater and greater amounts of federal debt that will necessarily require fiscal tightening.

In advance of these shifting demographic trends, rather than run surpluses, the government has run deficits – primarily as a result of lost tax revenue during the recession, a series of tax cuts in 2001 and 2003, a large increase in defense spending since 2001, and emergency fiscal measures during the financial crisis and Great Recession.

Although most everyone agrees that the current fiscal stance is unsustainable, there is bitter political discord over the best course of action. Republicans emphasize cutting spending, especially in the entitlement programs. Democrats prefer tax increases, particularly on the wealthiest taxpayers. Because of that disagreement and some peculiarities in how the budgeting process works, a number of tax cut provisions are set to expire at the same time across-the-board spending cuts are set to be enacted.

Q. Some say we’ve reached a point where drastic measures like this are necessary. Do you agree, or is the fiscal cliff avoidable?

A. As an economist, I’m not an expert on what types of threats are necessary for the nation’s political leaders to reach consensus on a long-term budget plan. Using common sense, it seems obvious that a fall off the fiscal cliff is avoidable. It’s in the country’s best interests and seems to be in the political interests of both Democrats and Republicans.

The expiration of the 2001 and 2003 income tax cuts are set to affect households at every level of income. The failure to limit the reach of the alternative minimum tax will probably lead to unexpectedly high tax bills for many households. Additionally, one would prefer to curtail spending in a more measured way than automatic across-the-board cuts. Finally, if the economy were to fall into a recession again, it would inflict financial pain on the nation and likely make the debt problem worse.

Q. Avoiding the fall requires a very polarized Congress to reach some sort of compromise. What happens if Republicans get their way in the negotiating process and Democrats don’t – or vice versa? What would each scenario mean for the average American?

A. Nobody wants to see across-the-board spending cuts, an increase in taxes for the bottom 98 percent of all taxpayers, or the greater reach of the alternative minimum tax. Republicans are pushing for a decrease in entitlement benefits that are most likely to affect younger people. In the future, they may need to save more and make plans to supplement the income and health security programs currently offered by the federal government.

Democrats insist on letting tax cuts for the top 2 percent expire at year’s end and insist on maintaining future entitlement benefits. The extent to which higher taxes on the top 2 percent affect the average American depends on whether they erode the 2 percenters’ incentive to work and invest. While economic theory is fairly clear that higher marginal tax rates distort incentives to work and start or expand businesses, evidence is mixed on how strong this effect might be.

Q. Do you see any indications that the looming cliff and any action to stop the country’s slide toward it are affecting our economy now?

A. A number of economists – including Ben Bernanke – have been making the case that uncertainty surrounding the fiscal cliff has been a significant restraint on the economic recovery. Surveyed businesses have cited this uncertainty as a reason to delay or avoid hiring and new capital purchases. A recent study by Stanford University’s Scott Baker and Nick Bloom, along with the University of Chicago’s Steve Davis, showed that high levels of policy uncertainty can negatively affect the economy.

Q. If no legislative action is taken to stop the tax increases and spending cuts, what can we as a country expect in terms of GDP and unemployment?

A. The CBO estimates that if we go over the fiscal cliff, the U.S. economy will contract 2.9 percent in the first six months of 2013, then grow by a tepid 1.9 percent during the next six months. It also projects that unemployment will rise to 9.1 percent.

There are reasons to be less pessimistic than the CBO. First, the Federal Reserve has been very aggressive in lowering short- and long-term interest rates by providing monetary stimulus, and there’s little doubt that monetary policy will become more accommodating if the fiscal cliff drags on the economy.

Second, there are actions the federal government could take to lessen the cliff-related burden at the start of 2013. For example, although marginal income tax rates would increase, it’s not necessary that the amount automatically withheld from worker paychecks increase right at the beginning of the year.

Third, the CBO’s model of the “multiplier effect” of fiscal policy probably overstates the negative impact of higher taxes and lower spending on the economy. However, because of the fragile nature of the current recovery, any further headwinds could potentially be very damaging to the nation’s economic health.