Fiscal Cliff Notes (December 3, 2012)

No rest for Obama after his re-election…the Petraeus Affair, Gaza Battles, Egypt Power Grabs, Will Susan Rice Be Named Secretary of State…all major headline news and the election is not even a month old.  But looming over it all is the “Fiscal Cliff.”

Perhaps you’ve read every "Fiscal Cliff FAQ" out there.  But if not, I’ll try to make this quick…

Various temporary tax breaks and benefits are set by current law to expire on January 1st:  the Bush era tax rate reductions, the payroll tax reductions and various extensions of unemployment insurance benefits.  The so-called “sequestration” cuts (put in as part of the debt ceiling deal, as a back-up plan if the “Super Committee” failed, which it did) will also take effect automatically on January 1^st.   And the debt ceiling needs to be raised again in February or March.

If all those tax breaks expired and the cuts actually occurred – that is, no deal -- that would take care of most of the deficit, just like that.  Tax revenues would rise by $400 billion in 2013 alone and the cuts are worth another $100 billion, thus reducing the deficit in 2013 nearly by half.  Sounds good, right, deficit hawks?

BUT… such a dramatic hit to household budgets (through higher taxes), combined with the loss of jobs and output that would ensue from the budget cuts would deeply and adversely impact the economy.  Virtually all economists agree that going over the “fiscal cliff” would drive the country back into recession.  (The non-partisan CBO estimates have unemployment rising to back over 9% and GDP in recession at -0.5%).  No one wants that…not even those deficit hawks, who suddenly realize that government spending actually does affect jobs – positively.

So, having agreed that the fiscal cliff must be avoided, the battle lines between Democrats and Republicans are basically drawn over tax rate increases versus closing loopholes and/or capping deductions.  Obama wants $1.6 trillion in revenue over 10 years, through a combination of those actions.  Republicans want to generate only $800 billion, with no rate increases, closing some loopholes, and that mysterious cure-all called “growth.”  (The more the economy grows, the higher are tax receipts.)  There are other battles to fight on the cost-cutting side, especially over the nature of entitlement cuts and defense spending.

It looks like the resolution will come in two parts, with Part One a short-term agreement, to avoid the Jan. 1 effects, on the structure of the “Grand Bargain” with a $50 billion “downpayment” of immediate deficit reduction.   Part Two would come over the next year as Congress addresses specific tax code reforms and structural entitlement change and other complicated issues.  But of course there is no agreement yet on any of that, including where the $50 billion comes from.

FEDERAL GOVERNMENT OUTLAYS AND RECEIPTS

I thought it might be useful to actually look at federal spending and receipts, over time.  It’s quite fascinating (well, to me).  I picked four points in time:  1992, what Clinton inherited, 2000 when W took over, 2008 when Obama came in, and 2011, the last full year for which we have actual data.  I put it all in 2011 constant dollars so inflation effects are minimized (below).

					Avg. Annual % Change
$ Trillion	1992	2000	2008	2011	Clinton	Bush	Obama	92/11
Receipts	1.7	2.7	2.6	2.3	6%	0%	-4%	1.6%
Outlays	2.1	2.4	3.1	3.6	1%	4%	5%	2.8%
Surplus/(Deficit)	(0.5)	0.3	(0.5)	(1.3)
GDP	9.7	12.9	15.0	15.0	4%	2%	0%	2.3%
Receipts % GDP	17.5%	20.6%	17.6%	15.4%
Outlays % GDP	22.1%	18.2%	20.8%	24.1%

There are a lot of numbers but you can see what is going on.  Clinton balanced the Budget because receipts grew a whopping 6% per year under him, driven by a strong economy; plus he kept spending down to 1% growth per year, very impressive.  He turned a $500 million deficit into a $300 million surplus.

Bush, on the other hand, instituted his tax cut in his early years and saw the economy crumble in his last years, thus reducing overall receipts.  Yet he increased spending by +4% per year, driven primarily by the wars, the new prescription drug benefit and continued entitlement growth.  He thus magically turned that $300 billion surplus into a $500 billion deficit, with mounting debt.

Obama, a true Keynesian, provided an $800 million stimulus to keep the bottom from falling out on the economy.  Since the stimulus was a combination of a $300 billion tax cut to go along with a $500 billion spending increase, this, of course, both reduced receipts as well as increased spending.

Republicans look at charts like this and say:  “It is blindingly obvious that Obama is incompetent.”  But Democrats look at it and say, “But what would have happened without the stimulus?”  Their point:  without the stimulus, spending would have been lower but so would receipts – by far.  An even deeper recession would have occurred, or maybe even a depression (-10% GDP….in Bush’s last quarter it was -6%).  Instead, thanks to the stimulus, which if anything was too small, the economy began to recover, albeit slowly.

Based on this chart, it would seem that the best way to balance the Budget is for both receipts and outlays to be about 18-20% of GDP.  That would put both at about $2.8 - $3.0 trillion.  Hence you can see while a “balanced” approach makes sense.  Trying to fix this simply by cutting spending is insane.

If you look at the spending detail (below) it is also instructive.  Most spending line items have grown between 2% and 5% per year since 1992, which does not sound bad except when you remember that these are constant dollars.  That’s a lot of growth above inflation.  Medicare and Social Security have grown consistently.  Defense grew under Bush, driven by the wars.  “Income Security” (essentially programs such as welfare and extending unemployment benefits and the like) and “other” (e.g., education and energy spending) rose under Obama.

Outlays Detail					Avg. Annual % Change
$ Billion	1992	2000	2008	2011	Clinton	Bush	Obama	92/11
Defense	462	386	644	706	-2%	7%	3%	2.3%
Medicare	184	259	409	486	4%	6%	6%	5.2%
Income Security	310	334	450	597	1%	4%	10%	3.5%
Social Security	446	538	645	730	2%	2%	4%	2.6%
Net Interest	308	293	264	230	-1%	-1%	-4%	-1.5%
Other	741	875	1,156	1,451	2%	4%	8%	3.6%

Basically, it is a vast understatement to say politicians love to cut taxes and loathe to cut spending.  As I’ve said to many of my friends, solving this impasse economically would be easy – the contours of what should be done are clear, and we’ve seen countless reasonable “Grand Bargains” floated, notably Simpson-Bowles (or is it Bowles-Simpson?).  But solving it politically – through the political process -- has proven nearly impossible.

This time around, Obama seems willing to test going over the cliff.  It’s not really a cliff, after all, the impact would not be immediate, per se, and quick action in January would pull everyone back to safety.  He was just re-elected with this issue squarely on the table, and he knows from exit polling and Pew that 60% of Americans favor taxing high income earners.  So I doubt he will blink on rates.  Several prominent Republicans have either embraced the tax rate increases or at least walked away from the Grover Norquist “No Tax Increase” pledge.

So let the drama build toward New Year’s…