Drastic deficit reduction isn’t worth going over ‘fiscal cliff’

By James McCusker Herald Columnist

Congress is steering us right for a “fiscal cliff” that will take us into another recession.

For most Americans it seems like some sort of bizarre re-enactment of “Thelma and Louise,” choosing to explore the Grand Canyon by driving their 1966 Ford Thunderbird over the rim. Should we all hold hands, or what?

Congress built this mess all by itself by passing laws that will pull the rug out from underneath the economy at year-end and ignoring other laws that expire then, which will have the same effect. Unless Congress acts to stop it, 2013 will start out with sudden tax increases and drastic spending cuts that will rock our fragile economic recovery.

In its latest forecast, the Congressional Budget Office surveys the height of the cliff we’re headed over. It projected the U.S. economy in 2013 to “contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half.” In even plainer English, we will immediately go into a recession, then recover in the second half of the year.

If the projection holds true, the 2013 self-induced recession would last six months, compared with the 18-month recession we went through in 2008-09. We are still staggering from that recession, though, and it’s hard to predict how our economy will react to a second pop to the jaw.

The reason why we are so close to this economic cliff are important only to the extent that it reflects just how dysfunctional Congress and the White House have become.

The dramatic cuts in federal spending are the work of the so-called Super Committee, which was formed to break the impasse over the federal budget. The charter forming this committee, however, said that if it failed to come to a consensus there would be substantial, mandatory budget cuts starting in 2013. Congress uses the term “sequestered” to describe the process, but they are still budget cuts.

As it turned out, the Super Committee failed to come up with a budget compromise, and here we are, facing the cliff.

The spending cuts would only account for about a third of the total reduction in the deficit, though. The heavy mischief will be done by sucking money out of the economy through tax increases.

The big numbers in these tax increases come not from new taxes but from the expiration of tax relief measures enacted to counter the effects of the recession.

On Dec. 31, the 2 percent reduction in the payroll tax will expire, which will increase tax revenues by $95 billion. Other tax relief expirations, including restoration of the full Alternative Minimum Tax (AMT) coverage as well as an assortment of tax credits and tax rate reductions, will raise individual and business tax bills substantially, about $399 billion in 2012.

It is hard to believe that suddenly pulling $607 billion out of the economy is going to help much, and the CBO has done a good job in attempting to estimate the negative effects on Gross Domestic Product (GDP). There are two factors, though, which will tend to make the impact even worse than they are forecasting.

The first is the effect on consumer confidence. Consumers will see less money in their paychecks, which is bad enough, but they will also realize that it was totally unnecessary — the result of avoiding responsibility and not part of an economic plan.

The second is the yo-yo effect on businesses. Taxes are up, then they’re down, now they are going up again, not as part of any known economic plan but almost randomly.

The annual federal deficit now is approximately $1.171 trillion, and the deficit reduction in 2013 is projected at $612 billion, or about 52 percent. There is absolutely no reason why we have to cut the deficit by more than half in one year and deliberately cause a second recession.

What makes more sense economically is to spread out the reduction over a fixed period. Whether we agree on a five-year or a ten-year period is less important than committing ourselves to a reduction plan that won’t wreck the economy. That would solidify our credit standing and restore sense and some stability to federal economic policy.

There was always something unreal and Hollywood movielike to both President Barack Obama’s Budget Commission and Congress’s Super Committee. And there is something unreal about the fact that irrespective of who wins the election in November, it is this same dysfunctional Congress, including any lame duck members, that must fix the tax and budget problems before year-end. That’s a Hollywood ending, all right – but the move is “A Nightmare on Main Street.”

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.