Fiscal Cliff: What Is It and Why Does It Matter?

With the fiscal cliff rapidly approaching, Questioning Authority spoke with James Hartley, professor of economics, about the economic decisions upon which President Obama and House Speaker John Boehner must agree.

Questioning Authority: What is the fiscal cliff?

James Hartley: The much-discussed fiscal cliff is an array of tax increases and government spending cuts that will go into effect on January 1, 2013. The major changes:

  • What we now call the Bush tax cuts expire, which will raise income taxes for nearly all taxpayers.
  • The 2-percentage-point reduction in the payroll tax (used to fund Social Security) expires, raising that tax on all those who pay into the system; since the tax phases out at high levels of income, this disproportionally affects lower-income earners.
  • There is an assortment of other tax or fee increases, including an increase in the estate tax and the costs associated with the recent health care legislation.
  • There is an automatic “sequestration,” which will reduce federal government spending by $110 billion, divided equally between defense and non-defense spending.
  • The extension of unemployment insurance ends, which will immediately end payments to around 40 percent of those receiving benefits.

QA: How did this happen?

JH: It was a deliberate decision made by Congress and the president last year. After negotiations about reducing the budget deficit failed, Congress and the president agreed that they would figure out a long-term solution within the next year. Since such a promise isn’t very credible, they put in place the fiscal cliff. The idea was to create a situation so terrible that everybody would know that a long-term solution needed to be found. To the surprise of nobody, Congress and the president did not reach a solution during a presidential election year. And so, after the election, we are all now discussing the fiscal cliff.

QA: What would be the impact of these changes, if they were to happen?

JH: Most forecasts suggest that if we go over the fiscal cliff, things will be pretty bad. A recession is highly likely. This was, after all, the whole point of creating the fiscal cliff in the first place.

QA: Is a deal likely? What would it look like? What timeframe do politicians actually have to come up with a deal?

JH: There are three possible outcomes here:

  • In the next month, Congress and the president agree to a long-term budget that significantly reduces the federal government deficit. I have not yet seen anyone who thinks this is likely; if they could easily reach a budget deal, they would have done so at some point in the last six years.
  • We go over the fiscal cliff. Not good. Everyone knows that.
  • At the last minute, Congress and the president pass legislation delaying the fiscal cliff. Since the fiscal cliff is an artificial legislative creation, it can be eliminated by legislative action. On December 30, faced with either throwing the economy off a cliff into a recession or saying, in effect, “Just kidding” and pushing the fiscal cliff back six months or a year, it is not hard to imagine that the latter will seem quite desirable.

In the meantime, however, Congress and the president are going to engage in a grand game of “chicken,” in which both parties pretend they would rather go off the cliff than compromise. (For those unacquainted with the game of chicken, the most famous representation of the game is in the film Rebel Without a Cause).

QA: What about the national debt?

JH: In the short run, failing to reduce the national debt will not create giant problems. The interest rate on that debt is near zero, which means that savers around the world still see the United States government as one of the safest borrowers in the world.

Right now, the U.S. national debt is about $16 trillion. That is a big number, slightly larger than U.S. gross domestic product. If the federal government simply stopped running deficits, over time, as the economy grows, the debt burden would decline. Curiously, any attempt to significantly reduce the deficit immediately will necessarily involve a collection of large tax increases and spending cuts, which looks a lot like the fiscal cliff. Long-term economic growth is thus the easiest way to rescue the deficit.

But that $16 trillion debt is not the real problem. The Social Security and Medicare systems are also facing looming deficits. These deficits are simply a demographic inevitability. As the baby boomers retire, the number of people collecting retirement benefits from the federal government will increase rapidly. We know the expected debt that is coming. The future liabilities of the federal government from the assorted retirement programs are around $90 trillion. But, that’s not even the complete picture. If you compare the long-term forecasts for what the federal government has promised to tax and spend, the true debt is $222 trillion. That’s a big number. A really big number. In a decade or two, all the current antics surrounding deficit reduction are going to look like the easy years of managing the national debt.