The Do-Nothing Fiscal Fix: Recipe for Recession

By :: September 1st, 2011

Given Washington’s endless partisan nastiness—and thanks to some updated estimates by the Congressional Budget Office--it seems like a good time to revisit an old idea: What would happen if Congress and the White House just closed up shop for a couple of years and let fiscal policy run on autopilot?

The question is not so far-fetched, since it describes exactly what could happen if Congress’ budget super committee fails and Washington is still locked in political gridlock at the end of next year. The answer?  We’d dramatically reduce the projected short- and medium-term deficit and probably throw the economy back into recession.

Take a look at this CBO chart.  It may look familiar since my Tax Policy Center colleague Bob Williams used it just last week to describe the consequences of extending the 2001/2003/2010 tax cuts. He wanted you to focus on the dark blue area of the chart. But this time, think about the light blue part at the top.


In CBO-speak, this is the world of current law. In English, it means all of the Bush/Obama tax cuts expire at the end of next year, the Alternative Minimum Tax would hit about 20 million households, and Medicare instantly cuts payments to physicians by one-third. In addition, since August’s debt limit agreement would take effect as designed, discretionary spending would be cut across-the-board by 5 percent—with half of those reductions coming from the Pentagon.

Allowing taxes to rise and slashing discretionary spending would sharply reduce the deficit, all right. It would plummet from 8.5 percent of Gross Domestic Product this year to 3.2 percent in 2013 and 1.6 percent in 2014. The national debt would still grow, of course, but the increase would be manageable. It all sounds so simple.

There are just two flaws in this strategy. Unfortunately, they are pretty big ones.

The first is that without getting medical costs under control, these draconian steps still won’t fix the nation’s long-run fiscal problem.    

The second--more immediate—problem is that slamming on the fiscal breaks would likely wreck what may be a still-weak economy.  Compared to this year, spending in 2013 would effectively be frozen, while taxes are increased by $750 billion.  

CBO projects such a sharp dose of austerity would slash economic growth by between 1.5 and 3.5 percentage points in 2013. With most economists projecting a 2013 expansion of about 3.5, this could cut growth by between one-third and, well, 100 percent. Keep in mind that with interest rates at close to zero, the Federal Reserve couldn’t do much to help.  And, btw, while CBO doesn’t try to estimate what a new recession would mean for the deficit, it wouldn’t be pretty.   

I am in no way suggesting that bringing spending and revenues back into line is not a good idea. It is, and it would have long-run economic benefits. But policymakers have to put away the meat axe and get smart.      

Instead of arguing over whether the Bush/Obama tax cuts should expire at the end of 2012, lawmakers should reframe the debate around how to structure the revenue code so it makes sense. They need to stop pretending they can fix the deficit through discretionary spending alone and get serious about making significant but gradual changes in health care costs. And finally, they must design a fiscal plan than includes both short-term stimulus and real long-term  deficit reduction.  

Optimists say the very risk of recession caused by fiscal gridlock may be sufficient to convince Democrats and Republicans to reach a sensible deal. Maybe, but given the latest petty squabble over when the president should address Congress, that's hard to imagine. All I know is that if they don't get serious, we could very well be headed for Recession II.

4Comments

  1. The American Spectator : AmSpecBlog : Would a One-Year, $750 Billion Tax Hike Be a Good Idea?  ::  5:11 pm on September 1st, 2011:

    […] But that's what anyone who suggests that we could close the deficit by simply following current law is advocating. (Doing so would entail allowing all the Bush-Obama tax cuts to expire, letting the AMT hit 20 […]

  2. Michael Bindner  ::  5:26 pm on September 1st, 2011:

    In the short term, letting taxes increase on their own is not such a bad thing. I suspect that budget cuts already passed will be used offset the Doc Fix and AMT-fix extension. Letting the other cuts expire will only raise taxes at the lower levels a small amount, say $20 a week for most families. That is not the stuff from which recessions are made. The more important fix for the economy has to do with housing debt, not fiscal policy and it should involve something on the monetary side through QE3.

    More importantly, tax increases on the top 20% of earners will not slow the economy – just the opposite. Low taxes on the wealthy provide a nasty incentive for shareholders and management to offshore American jobs and generally hold the line on wages and beneifts. Letting tax rates go up is a start at changing the calculus that makes such productivity gains attractive. Indeed, they are bad business strategy, since they have resulted in customers who can’t afford the products of industry.

    I have no problem with gridlock putting taxes back to Clintonian levels. While the middle class was still in dire straights back then, that era seems like the golden age in comparison to the Bush and Obama years.

    On the health care front, the best way to make spending cuts is to program in revenue increases. The Hospital Insurance Payroll Tax has essentially turned into a VAT for earners over $250,000 a year. Expanding the HI tax and corporate profits tax to a VAT-like Net Business Receipts Tax, with offsets to employers who provide more services for their workers and retiree will fix the system long term without sacrificing quality of benefits.

  3. Ralph H  ::  11:32 am on September 2nd, 2011:

    It will be interesting to see what the president proposes as his Jobs package. I doubt it will work based on his track record of picking pork that provides no long term value added. One of his ideas is to extend unemployment insurance indefinately. This postpones the inevitable day of recenoning when the recepient has to choose a job at a market rate. This results in UCI rates higher than necessary and a real reluctance on the part of employers to hire early on the chance they can get a great person early. Limiting UC to 1 year would have shaved at least .5% off the 9.1% rate. Between being gun-shy on committing to a permanant hire (for UC and mandantory healthcare reasons, this is why the only game in town is to hire Temps, and that helps nobody and hurts confidence. If we add infrastructure projects, we need to ensure they are for worthwhile projects that add value and are not just paybacks to unionized favorites. In fact there should be no requirement to hire union workers (and also no restriction). Think of it; if we spend $500 Billion on projects that are loaded to hire people at $20/ hr it will get many more people off the rolls than one that restricts to hiring teachers or union cpnstruction workers. I know mr Obama will ignore my help, but he would dramatically improve his result if he listened to me!

  4. AMTbuff  ::  1:51 pm on September 3rd, 2011:

    >The first is that without getting medical costs under control, these draconian steps still won’t fix the nation’s long-run fiscal problem.

    This is why it was such a horrible idea to spend $1T on a health care “reform” that did not cap federal health care spending as a percentage of GDP. It just added more to the spending problem.

    As to the autopilot question, a better analogy is a hostage taker who has set a time bomb. In this case taxpayers are the hostages and Congress the hostage taker. Do nothing and the bomb goes off. Who would NOT blame the hostage taker for the result?

    Incidentally, decreasing the AMT exemption by $30,000 (as in current law) creates a tax increase of $7,500 for anyone paying AMT or close to the borderline. Maybe the truly rich can afford it, but that’s a very major increase for an urban middle class family making $150k to $200k. The increase would be repealed retroactively after the April 15 outcry.