The Fiscal Cliff

The Fiscal Cliff is the popular term given to the scheduled expiration of mostly tax increases and spending cuts that will take effect as certain laws expire this coming January. Expiring tax provisions include the Bush tax cuts, tax cuts enacted as stimulus measures such as the payroll tax holiday and a provision limiting the expansion of the Alternative Minimum Tax[1]. Spending provisions from the Budget Control Act (the debt ceiling deal) will reduce discretionary spending and extended emergency unemployment benefits will expire starting in 2013.

In the coming decade, the expiration of these policies will reduce budget deficits to around 1.4% of GDP per year and debt from 73% to 61% of GDP. Failure to let these provisions expire will result in debt increasing to 93% of GDP by 2022. In the long run growth will be lower if these provisions never expire.

However, in the short run, given the weak state of our economy[2], allowing every provision to expire at once will cause the economy to contract and unemployment to rise. The Congressional Budget Office (CBO) forecasts the fiscal cliff will knock growth down to 0.5% over the next year and increase unemployment to 9.1%. The annual growth of 0.5% breaks down to negative growth of 1.3% on an annualized basis[3] in the first half of the year before recovering to grow by 2.3% annualized by the second half. Put simply, with the fiscal cliff, the worst year of the recovery has yet to happen. I personally find the CBOs non-cliff growth forecast to be too optimistic. But the size of the hit is the same; the CBO provides what is most likely a very best case scenario.

Those who think congress could never be as reckless to let this come to past should think back to the deficit ceiling drama. But even if it’s avoided, we are already suffering due to the uncertainty. The CBO estimates that the uncertainty alone will reduce growth in the second half of the year by 0.5% annualized. J.P. Morgan reports that 61% of its clients say the fiscal cliff is affecting their hiring plans. Economists Sylvain Leduc and Zheng Liu of the Federal Reserve Bank of San Francisco estimate that uncertainty has already added 1% to the unemployment rate.

Given the reality of the situation, simply delaying all elements of the fiscal cliff would be better than letting it happen. But the tax policies should expire first, and for the wealthy first. Even if none of the spending cuts take place, discretionary spending (the spending that is appropriated annually as part of the budget process) will still finish the decade below its 40 year average. And our tax system needs simplifying reforms to raise revenues. But the undeniable truth is that our debt problem cannot be solved by tax increases and discretionary spending cuts alone. Mandatory spending, especially on health programs, such as Medicare, Medicaid, and Social Security, will sink us eventually. If we can’t reform those programs, the only outcomes of the fiscal cliff debate are to ruin our economy now, or delay the inevitable by a matter of years later.





1. The AMT is basically an income tax that kicks in if you make income over a certain threshold. Above that income threshold, if you can claim enough deductions and exemptions to otherwise pay less tax than the AMT rate, you must pay the AMT rate. It was designed to be for high income households, but it isn’t indexed to inflation so it is creeping into the middle class. A more detailed explanation can be found here.

2. Recent IMF research has found that the negative growth effect of spending cuts is greater in times of economic weakness.

3. Basically, annualized rate means the percentage as if it lasted a year. 0.25% growth in a quarter is 1% at an annualized rate (0.25% multiplied over 4 quarters.