The Fiscal Cliff: Worst-Case Scenarios

The fiscal cliff is dominating the news these days, but mostly it is political theatre, and as I said before, I don’t think we will be going off.  All parties want a resolution, so even if the fiscal cliff isn’t resolved prior to the new year, it will be soon after, with changes retroactive to January 1.  But, what if I’m wrong?

If we actually go off the fiscal cliff and no new agreement is made, the tax structure would go back to what it was at the end of the Clinton era, and federal expenditures would be cut by less than 1%.  How bad would that be, really?

Some details: Taxes would rise because everyone would be pushed to higher tax brackets, and because the temporary reduction in Social Security payroll taxes would expire.  But, that was supposed to be temporary anyway.  And, the capital gains rate would go from 15% to 20%.  Both sides are against these increases, but part of the stalemate is that they want different resolutions.  On the spending side, the aggregate reduction in expenditures would be almost too small to notice, but because many expenditure items (Social Security, Medicaid, salaries (including military pay), pensions) would not be cut, other areas would be cut more.  Defense expenditures would be cut (but there is an argument to be made that this would be desirable).  Many people would lose their unemployment compensation.  Some people would see bigger impacts than others, but in the aggregate, the tax impact is more significant, and despite higher tax rates the economy did OK in the 1990s.

This appears to be more like a fiscal bump than a fiscal cliff, and look at the details; if we did go off, how bad would that be?

The main problem the fiscal cliff creates for the economy, as I said in my earlier post, and as Carl Close illustrated, is the uncertainty it creates about how it will be resolved.  We know the government budget is in for some possibly-major changes in the next month or so; we just don’t know what they are.  So, businesses and consumers are being justifiably cautious until the uncertainty is resolved.  But, for a government running trillion dollar deficits, a small cut in expenditures coupled with an increase in taxes would not be a calamity.

The ongoing federal deficit does pose some serious fiscal challenges to the parties gaming over the fiscal cliff.  One possible outcome is that they will come to a meaningful agreement that will put the government’s long-term fiscal problems behind us, but I’m willing to bet against that outcome.  Another possibility is that they will come to an agreement that will further cement those fiscal imbalances into place, making it even harder in the future to address the federal government’s budgetary issues.  Yet another possibility is that to resolve the current “crisis” they will put into place a temporary agreement that will just kick the problem further down the road.  That type of temporary agreement is what produced the fiscal cliff to begin with, and would produce a continuation of the uncertainty that plagues the economy today.

Looking at the possibilities ahead with the fiscal cliff looming, it appears that actually going off the fiscal cliff would be more desirable than the way this stalemate is likely to be resolved.  The worst-case scenario in the fiscal cliff drama is not going off the cliff, but what the political leadership is likely to do to prevent it.

Meanwhile, in keeping with the political theatre, when they do come to an agreement, you can be sure that the president and Congress will be praising themselves for what they will have done to us.

Randall G. Holcombe is Research Fellow at the Independent Institute and DeVoe Moore Professor of Economics at Florida State University. His Independent books include Housing America: Building Out of a Crisis (edited with Benjamin Powell); and Writing Off Ideas: Taxation, Foundations, and Philanthropy in America .
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