To begin, it is important to understand what we consider part of the fiscal cliff debate compared to what we view as items considered “off the table.” First, we expect that the short-term payroll tax cut will expire next year as scheduled along with extended unemployment benefits and the accelerated, or “bonus”, deprecation on capital equipment. Because of an absence of interest in extending these three policies inside the Beltway, we do not count any of these policies as part of a fiscal cliff deal. Second, the Affordable Care Act dictates that the capital gains tax rises by 3.8 percent next year to a total rate of 18.8 percent, regardless of the outcome of the fiscal cliff debate.1 All of these assumptions are currently built into our baseline forecast as published in our November Monthly Economic Outlook.
Included in the fiscal cliff debate are the following tax provisions as summarized by the Congressional Research Service2:
- Bush-era tax cuts reduced income taxes through lower across-the-board rates, reduced the marriage penalty, repealed limitations on personal exemptions and itemized deductions, expanded refundable credits, and modified education tax incentives. In addition, the Bush-era tax cuts reduced estate taxes by increasing the amount of an estate exempt from taxation and by lowering the estate tax rate.
- The patch for the Alternative Minimum Tax, or AMT, which increased the amount of income that is exempt from the AMT, and allows certain personal credits against the AMT that prevents an estimated 26 million additional taxpayers from being subject to the AMT.
- Tax credits and deductions (known as tax “extenders”) that affect individuals, businesses, charitable giving, energy, community development, and disaster relief.
In addition to the expiring tax provisions above, $1.2 trillion in automatic cuts to federal spending (known as sequestration) over the next 10 years would go into effect per the Budget Control Act of 2011.3
Three Options for Addressing the Fiscal Cliff
In the coming days and weeks, policymakers will have several options to address the impending fiscal cliff. In order to streamline our analysis, we present our probability weights for three possible scenarios that could transpire. In addition to the three possible outcomes, there are other routes policymakers can take within each of the choices described below. While it is very difficult to forecast exactly what a deal may look like, we feel it is important to convey our general thoughts around the possibility of each of the potential outcomes below.
Short-term deal to extend current policy (60 percent)4:
A short-term deal that temporarily extends tax cuts and similar spending levels for at least three months remains our baseline scenario, and what we have built into our latest economic forecast.5 Under this outcome, all of the Bush-era tax cuts are extended and the spending levels in place under the current continuing resolution passed in September will continue for the duration of the short-term window (likely 3-6 months).6 This kick-the-can down the road approach will also likely include some framework for a longer-term deal such as a deficit reduction target and a revenue increase target. This deal, if it transpires, would likely not occur until the final hours of December thus perpetuating the uncertainty that will weigh on fourth-quarter economic growth. In addition, the absence of a resolution or long-term deal would translate into uncertainty on the part of businesses and consumers beginning in 2013, which would hold headline economic growth to just 1.0 percent in the first quarter of next year. After a longer-term deal is reached in the middle of next year, growth would gradually return to its new long-term trend of around 2.0 percent.
Long-term deal in lame-duck session (0 percent):
Under a long-term deal, which we do not believe is politically or practically feasible during the lame-duck session, a long-term deficit reduction target would be set along with tax increases and initial spending cuts. While it is not clear what a long-term deal would include in the lame-duck session, the deal would most likely include some tax increases and perhaps a cap on income tax deductions along with a partial reversal of the sequester to spread the federal budget cuts out over a longer period of time. Speaker Boehner has come out and indicated that more time will be needed for a long-term deal.7 In addition, the Senate and White House insist that tax rates must increase for high income earners, a demand the majority in the House currently does not support. Based on this political gridlock, we believe that more time will be needed before a long-term deal can be struck.
Policymakers allow the nation to go over the fiscal cliff (40 percent):
As we indicated in our report after the election, a divided Congress for at least two more years increases the probability to 40 percent, in our estimate, that the nation goes over the fiscal cliff.8 In this scenario, all of the tax increases described above would go into effect and the full sequestration would go into effect.
There is, however, a way Congress can retroactively enact some tax increases and reverse part of the sequestration. In fact, if leaders take us over the fiscal cliff, it is likely that some reversal of tax increases and spending cuts would take place. The reason we have increased our weight for this scenario is that the gridlock in Congress over the past year may make going over the cliff a more politically feasible solution. If Congress lets the tax cuts expire and the sequestration goes into effect, the new Congress could come back in January to pass a new set of agreed-upon tax cuts (as opposed to extending current Bush-era tax cuts) and set new long-term spending reductions with much less severe near-term budget cuts. Some lawmakers see this option as a way to have a fresh start on tax and spending policy. The major concern with this outcome is that the uncertainty among businesses and consumers would lead to a severe impact on spending and thus growth until a deal could be passed.
If policymakers send the nation over the fiscal cliff without a deal to avert at least some of the tax increases and reduce some of the spending cuts, the result, as we have previously stated, would be a recession. In the next section we recap our views on the impact to economic growth of going over the fiscal cliff without further intervention from Congress.
Fiscal Cliff Forecast Comparison
In the event that Congress and the president allow current law to go into effect next year, the result would be a recession beginning in early 2013. Figure 1 below presents our forecast as of our November Monthly Economic Outlook compared to what we believe would happen if the nation were to go off the fiscal cliff. These estimates have been updated based on our November Monthly Economic Outlook and new information on the magnitude of the various policies under the fiscal cliff.9 We now expect that going over the fiscal cliff would result in economic growth for 2013 declining 0.2 percent for the year, as a technical recession would begin in the first quarter of 2013 and likely extend through the third quarter of 2013.
After going over the fiscal cliff, consumer demand would immediately slow as a result of the large increase in taxes, dramatically reducing after-tax income. In addition, business spending and thus employment growth would grind to a halt as businesses brace for a recession. The sharp pullback in consumer spending in the first quarter would translate into positive inventory building, which would have the effect of reducing the drag on second-quarter growth. Over the entire 2013 period, government spending cuts would sharply subtract from headline GDP growth, as the federal government would pare back spending and budget pressures would re-emerge at the state and local level from reduced sales and income tax collections and cuts to federal grant programs. While the most severe effects from the fiscal cliff would likely be realized in 2013, there would be some spillover effects into early 2014, especially from cuts to government spending.
Estimated Effects from Various Policy Outcomes
In order to determine the effects on our forecast from the various policy choices facing lawmakers, we have adopted the Congressional Budget Office’s (CBO) estimated effects on 2013 fourth-quarter growth and translated these effects into our forecast framework.9 The CBO’s baseline scenario assumes current law goes into effect thereby sending the United States over the fiscal cliff. Our assumption, that policymakers redact certain policies and thus we avoid the fiscal cliff pairs nicely with the CBO’s alternative fiscal scenario. Based on these similarities, we can adjust our baseline forecast downward in accordance with the CBO’s estimates of upward adjustment to its baseline forecast.10
Figure 2 below presents our real GDP growth rate through the end of 2013, which shows little difference between our forecast for the quarter and the CBO’s, thus, we can utilize the CBO’s estimated impacts to determine how our forecast for the quarter would change under each of the policy options listed in Table 1 below.
Currently, our forecast for economic growth in the fourth quarter of 2013 is for 2.2 percent annualized growth. While many would agree that 2.2 percent economic growth is already modest at best, our forecast assumes that we avoid the fiscal cliff through enacting a short-term deal. However, with many of these tax reductions on the table, we have examined what it would mean for economic growth if such assumptions do not hold.
The Budget Control Act (BCA) will impose automatic spending cuts to defense spending totaling $24 billion for 2013.10 Due to the extent to which defense spending contributes directly and indirectly through other industries, notably manufacturing, to the economy, the reduction of such spending could have large ripple effects. If policymakers do not eliminate these automatic spending cuts, GDP growth would be further reduced by 0.4 percentage points in the fourth quarter of 2013. Similarly, maintaining the automatic reductions to nondefense spending as specified in the BCA along with Medicare’s payment rate for physicians could subtract an additional 0.4 percentage point from real GDP in the fourth quarter. Therefore, eliminating the automatic spending cuts, both discretionary and nondiscretionary, that were imposed by the BCA provides 0.8 percentage points to economic growth in the last quarter of next year.
The tax provisions enacted over the past decade, including the ones that were originally set to expire in 2011, helped pad the wallets of consumers during the recovery. Consumer spending accounts for around 70 percent of GDP, therefore at a time when the economy is struggling to gain momentum such relief on the consumer supports economic growth. If policymakers were to eliminate most expiring tax provisions, excluding the payroll tax relief that has been in effect since January 2011, and furthermore, decide not to index the Alternative Minimum Tax for inflation, such measures would detract 1.4 percentage points from real GDP growth in the fourth quarter of next year. Moreover, if we wish not to extend tax breaks for higher income individuals, the economy will still receive a 1.3 percentage point hit to economic growth.
Maintaining the existing law, where all of the tax cuts expire and the sequestration goes into effect, would have a significant impact on economic growth, bringing our estimated 2.2 percent baseline economic growth rate for the fourth quarter of 2013 to an abysmal 0.0 percent rate. The severity of this outcome re-enforces the need for policymakers on both sides of the aisle to step up and make tough decisions about the future of tax policy and federal spending, especially spending on entitlement programs.11 The faster Congress and the administration address these challenges the sooner the U.S. economy can begin to slowly return to trend growth.
1 The Patient Protection and Affordable Care Act. (2010). P.L. 111-148.
2 Crandall-Holick, M.L. (2012). An Overview of Tax Provisions Expiring in 2012. Congressional Research Service.
3 Budget Control Act of 2011. (2011). P.L. 112-125.
4 Our baseline forecast as of our November Monthly Economic Outlook includes the assumptions presented on page 1 along with the short-term deal as presented in this section.
5 See our November Monthly Economic Outlook available on our website.
6 Continuing Appropriations Resolution, 2013. (2012). H.J. Res. 117. 112th Congress.
7 Parkinson, J. (2012). John Boehner Welcomes Big Deficit Deal, Pledges to Work with President Obama. ABC News.
8 See our first report titled “The Fiscal Cliff: Likelihood and Economic Impact” available upon request.
9 See our November Monthly Economic Outlook available on our website.
10 Congressional Budget Office. (2012). Economic Effects of Policies Contributing to Fiscal Tightening in 2013.
11 These entitlement programs primarily include Social Security, Medicare and Medicaid which have consistently been cited by the Congressional Budget Office as key drivers of increased long-run federal spending.