The Fiscal Cliff For Dummies, Part 2: The Economic Implications Of Extending The Bush Tax Cuts

Late last week, President Obama and House Speaker John Boehner began what promises to be two months of political posturing -- and much less likely, meaningful negotiation -- geared towards avoiding the impending "fiscal cliff."  I wrote about this much-discussed but little-understood cliff in the past, but now that the President has won reelection and Mitt Romney's promised extension of the Bush tax cuts, elimination of the AMT, and removal of Obamacare are off the table, the fiscal cliff  looms as a much more likely reality.

What follows is a detailed discussion of the cliff and its ancillary economic impacts. Let's get to the Q&A:

Q: In your last post on the topic, you defined the fiscal cliff as "the convergence of two events on December 31, 2012 — the expiration of almost every tax cut enacted since 2001 and a scheduled reduction in government spending — that, if the experts are to be believed, when taken together will threaten to bankrupt America, shift the world balance of power, and knock Earth off its orbit, sending it hurtling through cold, dark space."

While moderately entertaining, that definition didn't really explain a whole lot. Can you help me understand how reduced spending and increased revenue could be a bad thing in light of our current deficit?

A: Sure. While going over the cliff would improve our current deficit by adding net inflows, according to the people who are paid to project this sort of thing,  real GDP will drop by 0.5% in 2013 -- meaning we would experience negative growth -- and unemployment will rise to 9.1%. In other words, the fiscal cliff will kick-start a recession. The reasons why depend on which component of the cliff we're talking about: the reduced spending or the increased tax revenue.

Q: Man, I'm still confused. Let's start with the spending cuts….are they tied to the tax increases or are these two independent events?

A: It's a little bit of both. While the timing of the two events are coincidental, there is no denying that at a minimum, the required spending cuts are indirectly related to the expiring tax cuts in the sense that the foregone revenue resulting from the cuts contributed to our bloated deficit, which in turn contributed to our need to cut spending. More directly, however, the changes in governmental spending are the result of the "debt ceiling crisis" of August 2011.

Q: I sort of remember that, but I was really preoccupied with the 4th season of "Jersey Shore" that summer. Can you fill in the gaps?

A: Sure. When the government wants to build a bridge, wage a war, or pick up some extra padlocks for Area 51, they need a way to finance the expenditure. In general, these funds come from one of two sources: tax revenue or borrowings.

For a number of years, the government has spent significantly more than it collected in tax revenue, forcing it to borrow the excess. And as you might imagine, consistently growing deficits and debt are a rather bad thing. Higher debt leads to a reduction in national savings, undermines investor and consumer confidence, and jeopardizes the government's ability to continue to borrow at reasonable interest rates. Take these things together, and a fiscal crisis like the one experienced in Greece becomes a distinct possibility.

In light of these potential consequences, we can't allow Congress to run amuck with the ol' corporate credit card. As a result, there is a maximum amount of debt that can be incurred by the government, and this maximum is often referred to as the debt ceiling. During the summer of 2011, years of rampant spending finally caught up with the government, because it maxed out its borrowing capacity and run up against this debt ceiling.

Q: That sort of rings a bell. But we took care of all that, right? By the way, Season 4 was hilarious.

A: We did, but only in the most "U.S. government" sort of way. Rather than risk defaulting on our existing debt, we decided to raise the debt ceiling. Yes, you read that right….the government essentially punished itself for spending too much by increasing its ability to spend. Sound fiscal policy, right there.

But because Congress rightfully doesn't trust itself, it built in a safety measure in the form of a bi-partisan "super-committee" -- which isn't nearly as cool as it sounds -- that was charged with finding a way to cut $1.5 trillion off the national deficit over the next decade. In the event the committee failed to reach an agreement by November 2011, required spending cuts would kick in effective January 1, 2013, in an effort to slim our deficit and reduce our need for future debt. November came and went, and no agreement was reached. So here we are.

Q: Got it. So that's where the spending cuts come in?

A: That's right. And that's also why I said that the expiring Bush tax cuts were indirectly responsible for the required reduction in governmental spending. The tax cuts reduced rates and expanded credits, which obviously reduced tax revenue and in turn drove up the deficit and the government's need to borrow.

Q: So how sizeable are these cuts? And what exactly is being cut?

A:  Has anyone ever told you that you ask a lot of questions? Anyway, the reductions take aim at both defense and nondefense programs. On the defense side, spending for 2013 is to be cut by $24 billion, leaving America ripe for an attempted British re-colonization. With regards to nondefense programs, the government will be shelling out $40 billion less in 2013, with the reductions focused primarily on Medicare programs.

Q: So in total, that's $64 billion less the government will be parting with next year. How can that be a bad thing?

A: Great question, and as I mentioned above, the answer speaks to bigger issues regarding the fiscal cliff. While reduced spending is good in the long run, when the government is spending less, the government is buying less. Those goods and services that would have been purchased for $65 billion are now taken out of the economy, which leads to a short term recession.

To illustrate, if the required spending cuts prevent a bridge from getting built; there would be harmful direct and indirect impacts on the economy. Viewed in the alternative, if the bridge had been constructed, the government would purchase raw materials and labor, making for a banner year for one lucky contractor. Kill the bridge, and all those direct inflows to the economy go with it.

Extrapolating further, building the bridge would require a team of laborers, who would in turn earn more disposable income that they could pump into the economy by buying disposal razors, decorative throw pillows and the like. Nix the bridge and these workers hit the unemployment line.

Q: Now I got it. So how bad would the short-term impact be?

A: According to the Congressional Budget Office, if the government opted to postpone the required spending cuts for two years, the economy would pick up 3/4% in GDP and approximately 800,000 jobs in 2013, as opposed to the recession that would occur if the spending reductions are allowed to take hold and the tax cuts are allowed to expire.

Q: Ah, the expiring Bush tax provisions. So how do they fit in?

A: They are the other half of the fiscal cliff equation. As I mentioned earlier, effective January 1, 2013, almost every major tax cut enacted since 2001 is set to expire. In addition, on New Year's Day the President's signature "Obamacare" legislation, which contains several additional tax charges, will take hold. I've discussed this in the past, but for simplicities sake, I'll reproduce the detail of the expiring cuts here:

1. Bush-Era Tax Cuts: this includes the return of the current 10/15/25/28/33/35% individual tax rate brackets to the pre-2001 rates of 15/28/31/36/39.6%, the return of the tax-rate on long term capital gains and qualified dividends from 15% to 20% and 39.6%, respectively, and the return of the limitation on itemized deductions and phase out of personal exemptions.

2. Obama-Era Tax Cuts: on January 1, 2013, several provisions that benefit the lower classes — most notably the increased child tax and earned income credits and the expanded education credits — are slated to expire.

3. The Estate Tax: the estate tax exemption and tax rate are currently at $5,120,000 and 35%, respectively. Come January, they will return to $1,000,000 and 55%.

4. Expiration of the AMT Patch: The most recent patch raised the AMT exemption for 2010 and 2011 from $45,000 to $74,450 for MFJ. In 2012, this reset to $45,000, pulling tens of millions of taxpayers into AMT.

5. Temporary Payroll Tax Cut: For 2011 and 2012, the employee’s share of Social Security tax was cut from 6.2% to 4.2%. This rate cut expires at year end.

6. Obamacare Taxes: Starting in 2013, taxpayers earning more than $250,000 will pay an additional 0.9% tax on their wages and 3.8% on their unearned income (interest, dividends, capital gains.)

7. Extenders: There are a host of provisions set to expire at year end that regularly do so, before Congress retroactively resuscitates them. Foremost among the “extender” provisions are the R&D credit and the personal deduction for state and local income taxes.

When these changes kick in, federal tax revenue is anticipated to increase by $438 billion over 2012.

Q: And let me guess…somehow this increased revenue is a bad thing?

A: Long-term, no. Short-term, yes. Obviously, if tax rates go up, people have less money to spend, which is bad for the economy. But it goes deeper than that. If employers are uncertain about the state of the economy in general, they tend to lack confidence that there will be a demand for their products in the future. As a result, they may defer hiring or increasing wages, which adds to unemployment and further dilutes the economy.

Q: How diluted are we talking?

A: The CBO estimates that if we were to extend the Bush tax cuts for all taxpayers and patch the AMT (items 1, 2 and 4), we would forego $330 billion in tax revenue in 2013, but rather than endure a recession, GDP would grow by 1.4% next year and 1.8 million jobs would be added to the work force over the next twelve months.

Q: Interesting. But I thought President Obama refused to extend the cuts for those making more than $250,000? If we only extend the cuts for the lower and middle classes, would the boon to the economy be softened?

A: Here's the interesting thing: it doesn't appear to have any  material effect on GDP or hiring if we extend the cuts for all taxpayers, as the Republicans prefer, or just for those making less than $250,000, as President Obama has repeatedly promised.

Check out this comparison for 2013:

Impact	Extend Bush tax cuts for all	Extend for those earning < $250,000
Lost tax revenue	$330 billion	$288 billion
Effect on GDP	Increase 1.4%	Increase 1.25%
Increase in jobs	1.8 million	1.6 million

The reasons kind of make sense: if we extend the cuts for the nation's wealthiest, those taxpayers will obviously have more cash. Becausee high-income taxpayers tend to save a larger portion and spend a smaller portion of each extra tax dollar they receive, however, handing the rich extra dollars doesn't translate into a huge bump in the economy.

Clearly, this can, and likely will, be spun in the favor of both parties. Republicans will argue that since there is virtually no difference in the impact on the economy, the President should extend the cuts for all taxpayers. The Democrats, of course, will maintain that the numbers support their position that the President can increase the tax on the nation's rich and collect the related additional tax revenue, all without having a detrimental effect on economic growth.

Q: OK, so what if the government goes all in and gets rid of the spending cuts, extends all the Bush tax cuts, and patches the AMT? What would that do for our economy in 2013?

A: If we go that route, we would forego the opportunity to trim $394 billion off our deficit, which may not be the ideal fiscal policy. The upside, of course, is the immediate impact on the economy. These changes would grow GDP by 2.2% when compared to going over the cliff and add 2.6 million jobs.

Q: Got it. If we want to remain on the path of economic growth, we've got to get rid of the spending cuts and tax increases and stay the recent course. But you wrote a couple of times that while the short-term impact of going over the cliff would result in a recession, it would be beneficial in the long-term. Can you explain?

A: If the government is willing to go over the cliff, it would trim the 2013 deficit by $500 billion (when you also account for the new Obamacare provisions and the expiration of the temporary 2% payroll tax cut) and could presumably get its borrowing under control. If this were to occur, while there may be a short-term recession, after 2013 economic growth will pick up and the labor market will improve. As a result, the unemployment rate will drop to 5.5% by 2018. This is, again, all according to the CBO.

And here's one additional thing to think about: many economists believe that even if the fiscal cliff is avoided by doing away with the spending reductions and extending the Bush tax cuts, the economy will continue to underperform for the next few years and unemployment will remain high. Making matters worse, if we opt for this short-term patch the deficit will remain around $1 trillion in 2013, forcing the government to continue its borrowing ways and raising the risk of a Greece-level financial crisis.

Q: So is this a "damned-if-we-do, damned-if-we-don't" type thing?

A: I'm no economist, but it certainly appears so, doesn't it? The question becomes, are we ready to pull off the band-aid all at once and deal with the pain, or do we want to drag out the process over a period of years in hopes of evening out the discomfort? If we go over the cliff and get on the right track in terms of trimming our deficit, we'll head back into a recession in 2013. In the alternative, if we avoid the fiscal cliff we may preserve our recent economic growth, but by failing to address the government's bigger problem -- it's bloated deficit and outstanding debt -- we may end up worse off ten years from now.

Q: So what's the most likely solution?

A: I honestly don't know, and even if I told you my recommendation, you probably shouldn't listen to it anyway. I can tell you this though: there is no quick fix or magic bullet. As a country, we probably need to take a hard look at some of our policies and search for a more sustainable path. Whether it's raising taxes, reducing benefits for the elderly or decreasing military spending, some hard, unpopular decisions are going to have to be made.

The more interesting aspect is to what extent a divided Congress will be willing to attack the issue and reach a meaningful agreement before year-end. The Republican side is already pushing for much-needed tax reform resulting from an overhaul of the Code. This sort of reform requires reduced rates and simplifying base-broadening measures, and is embraced by many in the tax community. Unfortunately, this type of thing takes time, and reading between the lines, I view the Republican's position as a "let's do another short-term patch by extending the Bush tax cuts for a year or two and spend the interim investing in tax reform."

President Obama, however, has not budged on his refusal to extend the Bush tax cuts for the nation's wealthiest, and now that he's in his second term, what would make him do it now? He may well view his re-election as a referendum on taxing the rich, and stick to his guns.

If neither side is willing to budge, we may just go hurtling off this fiscal cliff, Thelma and Louse-style. Which would be awful. Or great. Depending on your point of view.

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