The Fiscal Cliff For Dummies, Part 2: The Economic Implications Of Extending The Bush Tax Cuts
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U.S. Speaker of the House Rep. John Boehner (R-OH) addresses the media during a press conference in the U.S. Capitol building November 9, 2012 in Washington, DC.
Late last week, President Obama and House Speaker John Boehner began what promises to be two months of political posturing — and much less likely, meaningful negotiation — geared towards avoiding the impending “fiscal cliff.” I wrote about this much-discussed but little-understood cliff in the past, but now that the President has won reelection and Mitt Romney’s promised extension of the Bush tax cuts, elimination of the AMT, and removal of Obamacare are off the table, the fiscal cliff looms as a much more likely reality.
What follows is a detailed discussion of the cliff and its ancillary economic impacts. Let’s get to the Q&A:
Q: In your last post on the topic, you defined the fiscal cliff as “the convergence of two events on December 31, 2012 — the expiration of almost every tax cut enacted since 2001 and a scheduled reduction in government spending — that, if the experts are to be believed, when taken together will threaten to bankrupt America, shift the world balance of power, and knock Earth off its orbit, sending it hurtling through cold, dark space.”
Tony Nitti 
Howard Gleckman While moderately entertaining, that definition didn’t really explain a whole lot. Can you help me understand how reduced spending and increased revenue could be a bad thing in light of our current deficit?
A: Sure. While going over the cliff would improve our current deficit by adding net inflows, according to the people who are paid to project this sort of thing, real GDP will drop by 0.5% in 2013 — meaning we would experience negative growth — and unemployment will rise to 9.1%. In other words, the fiscal cliff will kick-start a recession. The reasons why depend on which component of the cliff we’re talking about: the reduced spending or the increased tax revenue.
Q: Man, I’m still confused. Let’s start with the spending cuts….are they tied to the tax increases or are these two independent events?
A: It’s a little bit of both. While the timing of the two events are coincidental, there is no denying that at a minimum, the required spending cuts are indirectly related to the expiring tax cuts in the sense that the foregone revenue resulting from the cuts contributed to our bloated deficit, which in turn contributed to our need to cut spending. More directly, however, the changes in governmental spending are the result of the “debt ceiling crisis” of 2011.
Q: I sort of remember that, but I was really preoccupied with the 4th season of “Jersey Shore” that summer. Can you fill in the gaps?
A: Sure. When the government wants to build a bridge, wage a war, or pick up some extra padlocks for Area 51, they need a way to finance the expenditure. In general, these funds come from one of two sources: tax revenue or borrowings.
For a number of years, the government has spent significantly more than it collected in tax revenue, forcing it to borrow the excess. And as you might imagine, consistently growing deficits and debt are a rather bad thing. Higher debt leads to a reduction in national savings, undermines investor and consumer confidence, and jeopardizes the government’s ability to continue to borrow at reasonable interest rates. Take these things together, and a fiscal crisis like the one experienced in Greece becomes a distinct possibility.
In light of these potential consequences, we can’t allow Congress to run amuck with the ol’ corporate credit card. As a result, there is a maximum amount of debt that can be incurred by the government, and this maximum is often referred to as the debt ceiling. During the summer of 2011, years of rampant spending finally caught up with the government, because it maxed out its borrowing capacity and run up against this debt ceiling.
Q: That sort of rings a bell. But we took care of all that, right? By the way, Season 4 was hilarious.
A: We did, but only in the most “U.S. government” sort of way. Rather than risk defaulting on our existing debt, we decided to raise the debt ceiling. Yes, you read that right….the government essentially punished itself for spending too much by increasing its ability to spend. Sound fiscal policy, right there.
But because Congress rightfully doesn’t trust itself, it built in a safety measure in the form of a bi-partisan “super-committee” — which isn’t nearly as cool as it sounds — that was charged with finding a way to cut $1.5 trillion off the national deficit over the next decade. In the event the committee failed to reach an agreement by November 2011, required spending cuts would kick in effective January 1, 2013, in an effort to slim our deficit and reduce our need for future debt. November came and went, and no agreement was reached. So here we are.
Q: Got it. So that’s where the spending cuts come in?
A: That’s right. And that’s also why I said that the expiring Bush tax cuts were indirectly responsible for the required reduction in governmental spending. The tax cuts reduced rates and expanded credits, which obviously reduced tax revenue and in turn drove up the deficit and the government’s need to borrow.
Q: So how sizeable are these cuts? And what exactly is being cut?
A: Has anyone ever told you that you ask a lot of questions? Anyway, the reductions take aim at both defense and nondefense programs. On the defense side, spending for 2013 is to be cut by $24 billion, leaving America ripe for an attempted British re-colonization. With regards to nondefense programs, the government will be shelling out $40 billion less in 2013, with the reductions focused primarily on Medicare programs.
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