How Steep is that Fiscal Cliff ?

This is a comment in response to a post on CNBC's page,

" CNBC's Maria Bartiromo on the 'fiscal cliff': "Leave it to Washington to make the worst decision time and again. And we all pay the price."

Read her full commentary on the fiscal cliff & what Washington is doing to fix it:

Are you worried about the potential layoffs and economic impact that could come as a result of the 'fiscal cliff' at the end of the year? "

Are you worried ? 
Yes, unfortunately, this isn't a joke that ends with a trivial one word answer or an election result for that matter. 

                  Given the scale of this one can't help but wonder.. Is there anybody out there that really cares about America? Silence is a sad way to answer such a reality. It is high time this nation and its people learn and prepare to brace and cope with the effects and consequences of going down that steep cliff. To put it mildly, it is pathetic to even hear or read of this or the empty arguments, the lack of political will or urgency and the senseless indecision that defies all logic. This did not happen overnight, and no one has the clear means or basis to outline the scope, the effects and the impact it is going to have on the economy. Americans should thank their leaders for leading them down this path and should take personal responsibility for what they have to live with and what is in store in the coming future. Putting the budget on a sustainable path will require significant changes in spending policies, tax policies, or both and given the way things are this is not something that will materialize that easily. Looks like someone will have to magically enforce this action. 

       FYI: The cliff is a series of major policy changes that will happen automatically at the end of this year if Congress does nothing. The big players on the tax side are the Bush tax cuts and the payroll tax cut. On the spending side, the automatic cuts included in last summer’s debt ceiling deal will take effect. But there’s a lot more, as you can see in this table from the Committee for a Responsible Federal Budget:

        The combined effect will be a huge fiscal contraction, one which, according to conventional economic theory, could pose a real threat to the economic recovery. Here’s how the major provision break down by category, courtesy of the CBO:

         The biggest provision is the Bush tax cuts, followed by the payroll tax cut and the cost of indexing the Alternative Minimum Tax (AMT) eligibility cutoff to inflation.

           The payroll tax break expires this December, and the Bush tax cuts expire Jan. 1, meaning that new, higher rates will take effect the following year. Since payroll taxes are deducted from wages every week, the effect there will be immediate, whereas the income tax rate increases only affect income starting in 2013. If employers adjust withholding, the effects could come sooner, but if there are logistical hurdles to that, the economic dent could be delayed.
The sequestration cuts will take effect starting in January too, meaning their impact, like the payroll tax cut’s expiration, will be more immediate. The cuts are evenly split, with $27 billion each in 2013 for defense and non-defense spending, plus $12 billion in cuts to Medicare.

Crunching Numbers & Running the Equivalent of a 
Simulated Economic Crash Test

      If Congress does nothing, the U.S. will almost certainly go into recession early next year, as the combo of spending cuts and tax hikes will wipe out nearly 4 percentage points of economic growth in the first half of 2013. Since most estimates project the economy will grow only about 3 percent next year, that puts the U.S. solidly in the red.

         The CBO estimates that the total effect of these provisions is a 3.9 percent reduction in the growth rate of GDP next year — enough to make the year’s total growth rate negative, plunging the country back into recession. What’s more, the mere anticipation of this change will reduce GDP growth by 0.5 percent this year. This change is not evenly distributed between the cliff’s components, as this chart from the Committee for a Responsible Federal Budget shows:

           Eliminating or reducing the fiscal restraint to be scheduled to occur next year without imposing comparable restraint in future years would have substantial economic costs over the longer run. However allowing the full measure of fiscal restraint now embodied in current law to take effect next year would have substantial economic costs in the short run.

What might policymakers do under these circumstances? 

                        One possibility is to leave current law in place, accepting the short-run economic costs of sharp fiscal restraint in order to put the federal budget on a sustainable longer run trajectory. Another possibility is to extend all current policies for a prolonged period, accepting the longer-run costs and risks of surging federal debt for some time. 

          An intermediate possibility is to extend some but not all current policies indefinitely (perhaps with some offsetting changes in other policies) or to extend or enact certain policies for a limited period. In particular, if policymakers wanted to minimize the short-run costs of narrowing the deficit very quickly while also minimizing the longer-run costs of allowing large deficits to persist, they could enact a combination of policies: changes in taxes and spending that would widen the deficit in 2013 relative to what would occur under current law but that would reduce deficits later in the decade relative to what would occur if current policies were extended for a prolonged period. 

Such a combination of policies would use fiscal policy to support demand for goods and services in the short run, while the unemployment rate is high and many factories and offices are underused, but would impose fiscal restraint to bolster the economy’s production over the longer run, when output and employment will probably be close to their potential. That approach to fiscal policy would work best if the future policy changes were sufficiently specific and widely supported so that households, businesses, state and local governments, and participants in the financial markets believed that the future fiscal restraint would truly take effect. If such policy changes were enacted soon, they would tend to boost output and employment in the next few years by holding down interest rates and by reducing uncertainty and enhancing business and consumer confidence. 

              Enacting policy changes soon would allow for implementing them gradually while still limiting further increases in federal debt and the corresponding negative consequences. Although there are trade-offs in choosing when policy changes to reduce future deficits should take effect, there are important benefits and few apparent costs from deciding quickly what those changes will be.

P.S ~ A surf-style song, by country artist Merle Hazard, about U.S. fiscal dysfunction.

Jai Krishna Ponnappan