It's a Fiscal Slope, Not a Cliff
Quick question: What happens when you step down a slope? Well, if it's a steep slope you'll start sliding, but not so fast that you can't catch yourself, avoiding serious harm.
And that's exactly the situation Washington will face early next year, if it doesn't reach a deal on expiring tax cuts and new spending reductions before January 1. The nation is headed for a fiscal slope, not a cliff.
Let me explain. As we have all heard repeatedly, Americans are on track to pay hundreds of billions of dollars in higher taxes next year as tax cuts enacted under both George W. Bush and President Obama come to an end. Meanwhile, thanks to the failure of last fall's "supercommittee," mandatory spending cuts will hit both domestic and military programs.
But the cliff metaphor doesn't capture a worst case scenario in which Congress does nothng to change the current trajectory before January 1. Yes, such inaction could eventually produce a recession, as the CBO warned again today in an updated analysis, with unemploying spiking back up over 9 percent. (See my colleague Joe Hines' take on these effects here.) Before that downturned happened, though, Congress would still have time early next year to avert such pain because both new tax hikes and spending cuts would take effect at a moderate pace that in no way resembles a free fall.
Start with the tax hikes. According an analysis the CBO did in May, taxes will go up by $399 billion next year, with most of those increases coming from the expiration of the Bush tax cuts. The next biggest hit will be from the end of the temporary cut in payroll taxes.
That's a lot in extra taxes over an entire year. But on a monthly basis it works out to $33.2 billion being sucked out of the economy per month -- an economy that generates about $1.2 trillion in economic activity every month. And, in truth, that monthly number would likely be much lower in 2013, since some taxes owed for that year won't be paid until early 2014 when people file returns. So while again, this is still a much bigger fiscal hit than we want to see amid hard times, the effects kick in over time, not instantly. We'd be facing a cliff if $399 billion went poof on New Year's Day, 2013. But losing some fraction of that amount every month is a slope.
And, as I said earlier, you have time to recover when you're sliding down a slope. If Congress reached a deal, say, in early February to restore the Bush tax cuts for everyone but the top 2 percent -- in other words, a majority of those tax cuts -- and also extended the payroll tax cut, the effects on the economy would be moderate.
As for those spending cuts, the hit here is much smaller and also would take effect gradually. According to the CBO's analysis today, spending is set to fall by $110 billion next year. Averaged over 12 months, we're talking $9.1 billion a month during a year in which the federal government is set to spend roughly $3.5 trillion. While it's folly to reduce spending when the economy is weak, the scope of these cuts don't sound so disastrous. And, again, the cuts would kick in slowly. As the Center for Budget and Policy Priorities has noted:
While the limit on spending authority will be imposed at the beginning of the year, the actual reductions in spending will occur over the course of the year and into subsequent fiscal years. Once again, only a fraction of the impact occurs in the first month or so, although expectations of the cutbacks can affect the behavior of government contractors and others in advance of the actual cuts.
Huge tax hikes and sizeable spending cuts aren't smart public policy in the middle of a de facto recession. But Congress will still have time to prevent the worst of such folly if no deal is reached by January 1.
There is no fiscal cliff, and everyone should stop using that phrase.