Facing the fiscal cliff

With all of the talk about the impending fiscal cliff, policymakers seem to have focused on a narrow set of solutions. However, there are many fiscal paths the country could conceivably take at this juncture that will move us forward long term.

It is useful to frame the situation in the context of its two extremes. This is precisely what the Congressional Budget Office (CBO) did in its August Budget and Economic Outlook Report. The CBO report assesses both long- and short-term macroeconomic consequences of two very different fiscal scenarios.

In what it calls an Extended Baseline, the CBO first examines the economic impact of going over the fiscal cliff — allowing Bush-era tax cuts to expire for all income levels with substantial automatic spending cuts on everything besides major health programs, social security, and interest on the national debt.

The second, labeled the Extended Alternative Fiscal Scenario, is essentially the opposite of the first and assumes that current tax cuts would be extended or made permanent, and the automatic cuts due to take place under the rules of sequestration would not occur, and current spending outlays would continue.

Long-term effects

The long-term effects of these different scenarios are not difficult to imagine. Under the Extended Baseline, the combination of tax hikes and spending cuts would result in closing federal budget deficits and therefore a decline in the national debt from its current level 73 percent of GDP to 61 percent by 2022 and 53 percent by 2037. Moreover, the increased revenues and reduced spending would more than offset the projected rise in health care cost over the coming decades.

By contrast, the Extended Alternative would result in unsustainable levels of federal debt totaling more than 90 percent of GDP in 2022 and approaching 200 percent of GDP by 2037. The CBO further estimates the economic “drag” caused by rising debt levels would result in a GDP 4 percent lower in 2022 than it would be under the Baseline and 13 percent lower than the baseline by 2037. Furthermore, policies under the Alternative Scenario would result in higher interest payments on the national debt, severely restrict our lawmakers’ ability to aid the economy through fiscal measures, and would increase the likelihood of sudden fiscal crisis in the future.

Basing a decision solely on these long-term projections, it would seem clear that the Extended Baseline Scenario would be preferable. That is to say, given these two options our government should do nothing and therefore go over the fiscal cliff.

However, short-term repurcussions paint a different picture. Under the Baseline, the economy would experience a sudden shock as higher taxes and lower spending would constitute a drag on the economy in the short-term and thereby almost certainly precipitating an immediate recession. The CBO estimates that the fiscal cliff would cause the economy to shrink by half a percent in 2013. The economy would improve again the following year but would remain below its potential until 2018. Additionally, the baseline scenario sees unemployment to rise above 9 percent initially and then slowing moving back down to 5.7 percent by 2017.

Potential losses in Minnesota

Senator Tom Harkin of Iowa estimates that Minnesota would stand to lose $70 million in federal funding from the departments of Health and Human Services, Education, and Labor in 2013 alone. The state also stands to lose thousands of jobs when the economy has only started to improve.

By comparison, the Alternative Scenario would result in continued growth in the economy for the next several years, at least before growing debt begins to take its economic toll.

Thankfully, sound policy options fall somewhere in between these two extremes and are all some form of fiscal and political compromise. One of these middle paths is the one outlined by the President that includes some combination of increased revenue along with more modest spending cuts.

The trick is to go light on both tax hikes and spending cuts in the short-term while the economy is in recovery. As it gains traction, the economy will provide more jobs resulting in more consumer spending and, of course, higher tax revenue.

Only when these things occur does it make sense to tackle the more difficult long-term debt problem trough higher taxes and/or deeper spending cuts.

Justin Caron, of Minneapolis, is a Fellow at Minnesota 2020, a nonpartisan, progressive think tank based in St. Paul. He holds a master’s degree from the Humphrey School of Public Affairs at the University of Minnesota. This article first appeared on the Minnesota 2020 website.

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