The Case for Jumping Off the Fiscal Cliff (Even if We Fall Into Recession)

By James Kwak

President Obama and Mitt Romney agree: We must do something to prevent a steep and simultaneous tax increase and spending cut in early 2013. What if they're wrong?

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Non-fiscal cliff; Wikimedia Commons

In an election year, even the release of a routine, semi-annual report by the Congressional Budget Office can become fodder for grasping politicians. Obama's campaign claimed that Republicans are holding the middle class hostage by demanding tax cuts for the rich, while Romney's countered that both high unemployment and high deficits are Obama's fault.

The CBO report, however, says something else: We have a choice. The CBO, as it has for years, released both a baseline projection and an "alternative fiscal scenario." The baseline follows rules set in the Congressional Budget and Impoundment Control Act of 1974: notably, for the most part, it must assume that the law as currently written takes effect. The alternative scenario is intended to reflect a set of policies that seem more likely to be enacted; for the most part, it assumes that current policies (e.g., tax rates, Medicare reimbursement rates) will remain constant instead of being allowed to expire.

What most commentators and politicians have seized on is the baseline projection, which incorporates the end-of-year "fiscal cliff": the simultaneous expiration of the Bush-Obama tax cuts and automatic spending cuts required by last summer's bipartisan debt ceiling compromise. In that projection, growth goes down and unemployment goes up, for which each side is already blaming the other in advance.

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So Obama and Romney are both saying, "we have to prevent this -- on my terms." But what if we don't?

What neither side is saying is that if we do nothing--according to the baseline projection--the deficit problem goes away, at least for a decade. This is what happens to the national debt in the two scenarios. (Note how the dark line goes down over the next ten years.)

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But would we reduce the debt by sacrificing the economy? Not in the medium term. According to Table 2-2 (p. 37), real GDP in 2022 would likely be slightly higher in the baseline than in the alternative scenario. (That's GDP, the size of the economy, not the rate of GDP growth--although that would also be higher.) Real GNP in 2022 would be almost 2 percent higher.* Unemployment would be the same in both scenarios. (By the way, none of this should have been news to anyone. The CBO did basically the same analysis in 2010, when we faced the same situation.)

Now, you can argue with this analysis. The CBO essentially assumes that the recession is cyclical and will not affect potential output, as seen in the figure below. Severe recessions, however, can have a negative impact on human capital, and lead some people to drop out of the workforce. Perhaps more importantly, that gap between GDP and potential GDP represents the suffering of millions of households, and so it's better to close the gap sooner rather than later.

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But if you're going to cite the CBO, you should acknowledge what the report really says: We can bring the national debt under control in the medium term, simply by doing nothing, without hurting the long-term prospects for the economy.

What does "doing nothing" entail, exactly? This figure shows the difference between the baseline and alternative scenarios.

As you can see, it's virtually all tax cuts. ("Additional debt service" means additional interest payments because of larger deficits, so it could be allocated proportionately between "extend tax policies" and "prevent spending cuts.") So when we decide between the baseline projection and the alternative scenario, we're basically deciding whether to keep the huge tax cuts originally passed under President Bush in 2001 and 2003 (since extended under President Obama in 2010).

So in the end, this is what the CBO report really says: If we let the tax cuts expire, things will get worse in the short term. But in 2022, the economy will be bigger than if we extend the tax cuts, Americans will own a larger share of our economic output, interest rates will be lower (by 0.4 percentage points--see Table 2-2), deficits will be much smaller (0.9 percent of GDP versus 5.5 percent), and the national debt will be almost $8 trillion smaller.

I've explained previously why I think we should let the tax cuts expire. And I realize that we don't necessarily face a stark choice between the baseline projection and the alternative scenario: If I were king, for example, I would let the income tax cuts expire while expanding the payroll tax cut and various kinds of government spending in the short term.

But there is an answer to our deficit problems staring us in the face. The real question is why both parties are trying so hard not to see it.

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*The CBO uses GNP because, compared to GDP, it better reflects the impact of foreigners' claims on U.S. production.

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This article available online at:

http://www.theatlantic.com/business/archive/2012/08/the-case-for-jumping-off-the-fiscal-cliff-even-if-we-fall-into-recession/261555/