The impact of the fiscal cliff

I haven't gotten into the minutiae really except insofar as it concerns Kate's employer, but Bob Murphy gives us a chance to take a closer look at what's going on. His takeaway is that tightening is happening considerably more on the tax side than the spending side: "In summary, if we go over the “cliff,” the government plans on sharply reducing the budget deficit compared to its 2012 level. Of this $487 billion reduction in the federal budget deficit, the savings will come through two mechanisms:

== A cut of $9 billion in government spending (1.8% of the deficit reduction), and
== An increase of $478 billion in tax receipts (98.2% of the deficit reduction)."

There are a couple things that I think are worth noting about this. Bob is looking at the baseline projections, which is fine because all of the tax break expirations and automatic spending changes are in that baseline. But I don't find it the most helpful to look at just those changes, personally. The federal government spends a lot of money, its revenue is tied to the state of the economy, and its outlays are tied to the population, all of which is supposed to be growing over time. Think about consumption spending - lots of people were talking back in 2011 about how consumption spending wasn't depressed - it's back to the level it was in 2007! The problem with that logic is that consumption spending should have been a lot higher than 2007 levels by 2011, so it actually was depressed. So I find it more useful to look at (1.) comparison to a counterfactual, and (2.) changes in the percent of government spending as a share of the economy. That also helps pinpoint why some of these changes are occurring.

If you look at Table 1-6 of the same report that Bob was looking at (this is from the August CBO report - some November documents didn't seem to change much of the fundamental story), and if you look at the "alternative scenario" (which assumes all those automatic changes don't go through) and the percentage of the economy, this is what you see (I can't get it to be crisper without being too small - feel free to click through the link above):

So the "alternative" scenario is what happens if Congress completely avoids the fiscal cliff. The "baseline" is the full cliff. We will probably get something in between, if not in January then in the coming months. When you think like an economist and compare the baseline to the counterfactual offered by the alternative, you see that actually spending cuts make up a bigger part of this package than if you look just at fluctuations in the baseline series. In FY 2013 the baseline is about 67 billion lower than the counterfactual, and in FY 2014 it's 153 billion lower. Revenues in FY 2013 are 330 higher and in FY 2014 they're 383 billion higher. So I would characterize the full cliff as being about 70 to 85 percent tax increases, which is pretty much how it's been characterized I think (as a big tax hike). Even EPI makes a point of telling us that the tax increases are the biggest component.

It's a little heavier on the spending cuts than Bob's post implies because (1.) tax revenues are set to go up anyway because of expectations about an improving economy and this has nothing to do with tax rate decisions, and (2.) if you look at spending relative to its trend the cuts are deeper.

Whenever you are looking at a growing aggregate you should always think about it relative to its counterfactual trend line.

You can also see this in the percent of revenues and outlays as a share of the economy. Obviously the alternative scenario (our counter-factual) is badly imbalanced from a deficits perspective (that's the whole point of all this!). But when you compare that to the baseline as a percent of GDP you see again that the spending cuts here represent a permanent, approximately one percentage point reduction in federal spending (from about the mid 22 percents to the mid 21 percents), or a five percent cut. Likewise, tax revenue as a percent of GDP increases by about two percentage points (from the mid 18 percents to the mid 20 percents).

Something like this will be what we need a couple years from now. This is really not what we need right now when the labor market is still so weak.


So in summary, I think Bob is right to highlight what most reports have been saying already: that taxes represent the biggest chunk of this fiscal cliff. But I think by not comparing to a counterfactual or the trend line, he's seeing an imbalance that looks bigger than it actually is.

In any case, this is terrible policy in the middle of a recession although we do need to be thinking about our windows for  tightening up at some point. That's best left for a stronger economy, though (which does not mean we can't make deals now that take effect several years down the line).