Why a Fiscal Cliff Deal Could Cripple the Economy
Life + Money

Why a Fiscal Cliff Deal Could Cripple the Economy


The U.S. economy has been propped up for the past four years by more than $1 trillion of emergency stimulus measures, a phenomenon not seen since the New Deal.

The government showered struggling businesses and ordinary Americans with tax breaks, public works projects, unemployment benefits and special subsidies to help them get through the worst of the Great Recession. But when millions of Americans wake up on New Year’s Day, they may want to dive back under the covers when they discover their economic world in chaos. That’s when the last remnants of the Obama Administration stimulus will likely disappear.

Republicans appear willing to compromise on two critical issues—raising tax rates and taking the debt ceiling off the table as a fiscal cliff negotiating advantage. House Speaker John Boehner offered during a Friday call with President Obama to charge a higher rate on those making more than $1 million.

Even if Obama and Boehner agree at the last minute to extend the expiring Bush-era tax cuts for all but the wealthiest Americans, it’s almost certain that pay stubs will be smaller for many. That’s because a 2 percentage point reduction in the Social Security payroll tax likely will be eliminated. That change alone removes $1,000 a year from the average family’s paychecks. The deficit will in theory shrink by $115 billion next year with the return of the standard payroll tax rates used to finance Social Security, and roughly 143 million Americans will cope with less take home pay as a result.

At the same time, extended unemployment benefits could end for a couple million Americans, who have already been jobless for more than six months. Many of them will have to scramble to find ways to pay their rent and put food on the table, even if that means enrolling in other government programs. Finally, billions of dollars in specialized tax breaks to encourage hiring are on the cusp of extinction.

These stimulus measures have largely been overshadowed by the partisan wrangling over entitlement spending and income tax rates.  That all raises a disturbing question: Will the U.S. economy fall sideways without another year of stimulus?

“It’s not black and white that you either turn this on or off,” said Kevin Logan, chief U.S. economist for the bank HSBC. “These are conflicting goals. Each has their virtues.”

But higher payroll taxes come with an immediate price tag for an economy that relies on consumers. When the rates were first cut by two percentage points beginning in January 2011, disposable income jumped by $75 billion. Disposable income would drop by about $85 billion with the restoration of the standard rates, Logan predicted.

That translates into a severe drag in economic growth—about 0.7, according to Logan—when Gross Domestic Product is struggling to increase at a 2 percent clip. Because the economy has been so anemic by historical standards, Logan said, “There’s much less room for mistakes or sizeable fiscal contraction.”

The Congressional Budget Office projects that prolonging the payroll tax holiday for another year and maintaining the emergency unemployment benefits would raise real GDP by about three-quarters of a percent by the end of 2013 and create about 800,000 more jobs than currently being forecasted.

Conservative economists—who usually laud lower taxes — say the payroll tax holiday has done little to aid the country over the past two years and jeopardized the Social Security balance sheet at a moment when it’s starting to confront the demographic challenge of baby boomer retirements.

“It is a good thing that the payroll tax cut will end,” said Caroline M. Hoxby, a Stanford University economics professor and senior fellow at the conservative Hoover Institution.  “By having a payroll tax holiday, we are undermining the fiscal viability and, indeed, even the legitimacy of the programs that are supported by payroll tax.  These programs are supposed to be self-supporting social insurance programs.  Of course, they are not self-supporting now and probably won't be for decades.  This is the biggest fiscal problem that the U.S. has.”

Obama seems unwilling to abandon stimulus measures, although he might have to in order to finagle an agreement with congressional Republicans. As part of his offer to whittle down deficits by $4 trillion in the next 10 years, he included about $200 billion for stimulus spending in 2013. This led to GOP headshaking about a bait-and-switch that defeats the point of the $400 billion in reduced expenditures the president has proposed.

“Unfortunately the new stimulus spending they want almost outstrips all of the spending cuts that they have outlined," Boehner told reporters last week.

Besides continuing the payroll tax rates, Obama is asking for $30 billion for unemployment benefits, more than $50 billion in infrastructure spending, and another $27 billion in tax breaks. In the past, the president has capitulated on raising taxes on the wealthiest two percent of earners in return for more stimulus spending.

At the end of 2010 in order to introduce the payroll tax holiday, Obama agreed to extend all of the lower income tax rates first enacted under George W. Bush. The move offset some of the fading effects from the $825 billion in stimulus spending passed in 2009.

But that particular tradeoff will not happen this time, as the president insists that tax rates must be increased on incomes higher than $250,000 and maintained at current levels for the rest of the nation. In a sense, Obama is asking for the wealthy to offset tax breaks for the middle class in 2013.

Even some Democratic-affiliated economists are concerned about that plan, since any sharp tax increase could do economic harm as government spending contracts. Obama and Republicans are gambling that they can start reducing the deficit without hurting the economic growth that has flowed from borrowing cheaply. The abrupt kinds of shifts in policy being discussed by both sides could quickly upset hiring and only make the pull of the Great Recession harder to escape, said Robert Shapiro, chairman of the advisory firm Sonecon and an adviser to the presidential campaigns of Bill Clinton, Al Gore and John Kerry.

“There’s no doubt that the president’s opinion on high end tax cuts is contractionary,” Shapiro said. “All such matters ought to be phased in very slowly. The fact that the proposal comes from him and not the Republicans doesn’t make it right, doesn’t change its effect on the economy. The economy will slow and unemployment will probably start to rise again. Why would anybody want that?”