In the third quarter of 2011 the US Congress agreed to rather severe tax increases and spending cuts that would kick in as of January 2013, as a way to get a deal done to increase the debt ceiling. In addition, the Social Security payroll tax cut and extended unemployment benefits are also scheduled to go away in January.
All told, if nothing changes, this abrupt shift in fiscal policy would result in a hit to the economy of about $650 billion, or a little more than 4% of GDP, at a time when the economy is likely growing less than 2% a year.
Let me break down the major components of the Fiscal Cliff:
- 1. Abolition of the Bush tax cuts, which amount to $265 billion, of which $55 billion is for the “wealthy” and $210 billion for the “middle class” (everyone else). Almost no one on either side of the aisle wants to actually go forward with axing the tax cuts for the middle class. Republicans want to hold on to the top-level tax cuts, and to my mind that’s a bargaining chip (see below).
- 2. The Budget Control Act, or the debt-ceiling deal, comes in at roughly $160 billion, with $110 billion of that in sequestration, mostly for defense; and there seems to be a growing consensus that not all of these cuts should be made.
- 3. The 2009 stimulus will also roll off (this is the 2% Social Security break and extended unemployment benefits). This amounts to $140 billion all on its own, or almost 1% of GDP. Almost everyone agrees that these tax cuts were supposed to be temporary.
- 4. The “ObamaCare” $24-billion tax increase on high-income households is almost sure to be allowed to go through.
- 5. Technically, there is $105 billion in the temporary “doc fix” and Alternative Minimum Tax, which every year are supposed to expire and every year are postponed, which of course allows Congress and the president (whoever is in control) to project lower deficits in the future, even though those cuts never happen.
If you add the $105 billion of fixes in #5 and the middle class tax cuts, you get $315 billion, or almost half of the Fiscal Cliff, which reduces the impact to 2% of GDP. Take some of the sting out of defense and you get to less than 0.5%.
But this creates a big but… What is your fiscal multiplier? It is not so simple as looking at what the IMF manufactures as a number and then extrapolating. Without trying to be cute, the US is not Greece or Spain or Germany; we are perfectly capable of creating our own unique brand of chaos. It is all debt-related to be sure, but the similarities begin to break down when you look at the gory details.
Not all tax increases or tax cuts have the same multiplier, just as not all spending increases or spending cuts do. There is a big difference, as Gavyn Davies pointed out, between a fiscal multiplier of 0.5 and one of 1.7. Before we get into what our multiplier might be, let’s review a few facts.
If Something Can’t Happen…
There is a rule in economics: If something can’t happen, it won’t. That may seem a tad obvious, but so many people are prone to think that the current trend can go on forever. This time is different, we tell ourselves. Meanwhile I and many others – David Walker, David Stockman, Alan Simpson, David Bowles, et al. – are telling you that so much of what we’re doing is unsustainable that big changes in present trends, as much as we might not like to think about them, are inevitable. So what we must think about now is what will happen when major change is either forced on a country or else entered into willingly. Sometimes you have to think the unthinkable.
Look at the projected debt for the US, compiled by the Heritage Foundation, based on realistic assumptions, not compiled while wearing rose-colored glasses. This is a chart of something that will not happen. Long before we get ten years of multi-trillion-dollar debt, the bond market will begin to demand much higher rates than we currently experience, driving up our interest-rate cost as a percentage of tax revenues to very painful levels, forcing cuts in all sorts of things we currently think of as absolutely necessary – like the military, education, and Medicare spending.
One way or another, the projected budget deficits – whether the one from the Heritage Foundation or the official government projection – are going to come down. We can choose to proactively deal with the deficit problem or we can wait until there is a crisis and be forced to react. These choices will result in entirely different outcomes.
In the US, the real question we must ask ourselves as a nation is, “How much health care do we want and how do we want to pay for it?” Everything else can be dealt with if we get that basic question answered. We can substantially change health care, along with other discretionary budget items, or we can raise taxes, or some combination. Each path has consequences.
The polls say a large, bipartisan majority of people want to maintain Medicare and other health programs (perhaps reformed), and yet a large bipartisan majority does not want a tax increase. We can’t have it both ways, which means there is a major job of education to be done. But that is also why politicians seem to be advocating both objectives – their first order of business is to make sure they get re-elected.
The point of the exercise, to my mind, is to reduce the deficit over 5-6 years to some sustainable level below the growth rate of nominal GDP (which includes inflation). A country can run a deficit below that rate forever, without endangering its economic survival. While it may be wiser to run some surpluses and pay down debt, if you keep your fiscal deficits lower than income growth, over time the debt becomes less of an issue.
This is an outtake from Thoughts From The Frontline, a free weekly publication by John Mauldin, renowned www.frontlinethoughts.comexpert, best-selling author and Chairman of Mauldin Economics. Each week John provides his insightful analysis on Wall Street, the global markets and the rapidly changing world economy. Join his over one million readers today!