The Fiscal Cliff Is Less Than Three Months Away
October 19th, 2012 by Michelle Lui under Faculty Commentary. 1 Comment.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the October 2012 Longbrake Letter. To read the letter in its entirety, click here.
There is little new that can be said about the impending fiscal cliff. Details of the issues in play are well known. Nonetheless, enormous uncertainty is building because there appears to be little common ground between Democrats and Republicans and the outcome of the elections is anyone’s guess. We are in a waiting game until after the November 6th elections.
1. Continuing Resolution
Prior to adjourning for the elections Congress passed a continuing resolution to fund the government for six months through March 31, 2013. Spending levels will be maintained at fiscal year 2012 levels plus 0.612% increase across the board. This will maintain spending within the discretionary budget caps established by the Budget Control Act of 2011. The continuing resolution does not affect the automatic spending cuts, called the sequester, that automatically go into effect on January 2, 2013.
2. Mechanics of the Sequester
Everyone detests the sequester mandated by the Budget Control Act. Thus, it is likely to be eliminated. However, because it automatically goes into effect on January 2, 2013, unless Congress acts to eliminate it or defer the effective date, it could have at least a temporary impact. Because no one knows what Congress will do, preparations are already under way to implement the requirements of the sequester.
Beginning January 2, 2013 federal expenditures will be reduced at an annual rate of approximately $109 billion, evenly split between discretionary defense (95%)/homeland security (5%) programs and other discretionary domestic programs. Certain spending programs benefiting low-income households are exempted. Approximately $12 billion of the $55 billion reduction in discretionary spending will come from a 2% reduction in Medicare reimbursement rates; $38 billion comes out of other discretionary domestic spending; and $6 billion from certain domestic mandatory programs. These cuts amount to a 9.4% reduction in the discretionary defense budget and 8% reduction in other discretionary spending.
Percentage spending cuts apply equally to each budget category. Only within a budget category will there be flexibility to allocate the cuts. For example, there are 2,500 different accounts within the Defense Department’s investment budget and each must be cut by the same percentage.
Because the sequester is so blunt and onerous, it is unlikely to be permitted to take effect. However, a political compromise to eliminate it is likely to result in tighter aggregate spending caps, which would retain some of the intended impact of the sequester but permit judgment as to exactly what programs should be cut.
3. Impact of the Fiscal Cliff on Taxpayers
If Congress does nothing, approximately 90% of taxpayers will experience tax increases averaging $3,500 or about a 5% increase in tax rates. There would be modest progressivity to the tax rate increases with the lowest 20% of income earners experiencing a 3.7% tax rate increase and the top 20% a 5.8% increase. The tax rate for the highest 1% would rise 7.2%.
Disposable income would fall 4% on average. However, the lowest 20% of income earners would be hit by a 9% decline, primarily because of the loss of unemployment benefits.
4. Impact of the Fiscal Cliff on the Economy
Fiscal policy has had a modest contractionary impact on real GDP growth during 2012 – less than 1%. If we fall off the fiscal cliff, the contractionary impact will be about 3.5% in the first quarter of 2013. The impact will continue to be between 2.5 and 3.0% in the second and third quarters before falling to less than 1.0% in the fourth quarter. The Congressional Budget Office prepared a detailed analysis of the macroeconomic effects of the fiscal cliff in August which was summarized in the September Longbrake Letter.
5. Possible Pathway To Avert the Fiscal Cliff
Press reports indicate that a bipartisan group of senators is discussing a process to deal with the fiscal cliff. The first step would be to agree on a ten-year deficit reduction target. $4 trillion has been mentioned, but the number could differ somewhat from that level. There would be an understanding that the deficit reduction target would be reached through a combination of spending cuts, an overhaul of the tax code, which would have a net revenue impact, and adjustments to Medicare and Social Security. The second step would be to pass legislation that instructs relevant committees of Congress to draft specific legislation within six months. Importantly, if the second step failed to pass Congress, the alternative would be to adopt a plan similar to the Simpson-Bowles Fiscal Commission’s proposal. It is unclear at this juncture exactly what mechanics would be specified in legislation to assure action rather than prolonged stalemate.
Assuming that steps one and two are achieved, Congress would repeal the automatic spending cuts and delay implementation of the tax rate increases, but would probably also take some kind of interim step to make a down payment on deficit reduction.
Of course this is the stuff of compromise and as reasonable as it might seem, cutting through strongly held ideological positions will be very difficult. Democrats continue to insist that they will agree to nothing unless there is an immediate tax increase for wealthy individuals. Speaker John Boehner has been just as emphatic stating that Republicans will not agree to an approach that extends some of the Bush tax cuts but allows others to expire.
Of course, we expect posturing and rhetoric prior to the election. But, the hollowing out of the moderate center in Congress and the increasing dearth of respected statesmen in Congress strongly implies that it will be very difficult to forge a compromise after the election results are in.
If all else fails during the lame duck session of Congress, a six-month extension of most of the fiscal cliff issues is a possibility. This would include a delay in the implementation of the sequester. However, many believe that the payroll tax reduction would be allowed to expire as scheduled; extended unemployment benefits would be phased out; and the 0.9% surtax on individuals’ earnings over $250,000 and the 3.8% tax on passive income mandated by the Affordable Care Act would be allowed to take effect as scheduled.
6. Lame Duck Congress
Congress will return during the week of November 12th. The only issue of consequence will be dealing with the fiscal cliff. Action is unlikely to occur until mid-December. In 2011, Congress did not agree to extend the payroll tax cut until December 23rd.
If Congress fails to act before year end, the new Congress is sworn in on January 3, 2013. Presumably, dealing with the fiscal cliff would be the new Congress’s first order of business. This could become more complicated if Governor Romney is elected president as he would not take office until January 20th.
7. Possible Scenarios
GS has suggested four scenarios and attached probabilities to each:
Short-Term Extension of Most Current Policies (40%). This is the most likely outcome because it is one that would provide about six months for the New Congress to work through difficult issues. Certain matters such as the payroll tax cut would probably be allowed to lapse rather than receiving a temporary extension. The Republicans will insist on extending all of the Bush tax cuts while the Democrats will insist on letting the tax rate cuts expire for high income earners. For this option to occur either the Democrats or the Republicans will have accept the position of the other party on a temporary basis.
Fiscal Cliff Occurs (35%). As mentioned above, both Democratic and Republican leaders have articulated conditions that are unacceptable to the other party. Unfortunately, this increases the possibility that it will be impossible to reach compromise quickly. If neither of the parties emerges from the election with a clear mandate, the probability of this outcome will rise.
One-Year of Longer Extension of Current Policies (20%). This is the proverbial “kick the can down the road” option and would create a high likelihood that one or more of the rating agencies would downgrade U.S. debt.
Grand Bargain (5%). President Obama and Speaker Boehner almost agreed to a “Grand Bargain” in August 2011. In the aftermath of failure the recriminations were visceral. While this would be the optimal outcome for the American people and a version of it is what the bipartisan group of senators appears to be working on, it is probably the least likely outcome if government remains divided after the election as seems probable.
8. Debt Ceiling
Unfortunately, the debt ceiling will be reached sometime between December and February. There hasn’t been much commentary yet about the exact timing. Because of the enormous negatives that accompanied the August 2011 debt ceiling fight, Congress is likely to confine its work to deficit reduction and to enact temporary increases in the debt ceiling until there is a full-fledged deficit reduction agreement.
Jeffrey on October 25th, 2012
Going over the fiscal cliff is untenable to either party. Because of those pressures, post-election freedom, and a general bipartisan will to reduce debt, Congress will likely come to an agreement in the lame duck session. However, this agreement can be derailed quite easily. Were Barack Obama (assuming he does win, as polls seem to predict he will) to expend his limited political capital on another issue the US would fall over the fiscal cliff. Issues such as immigration, transportation infrastructure, or energy production are political third rails that would be more than capable of sapping the president’s persuasive power.