Keep this in the back of your mind

Today, the budget deficit is not “out of control”, and the “fiscal cliff” is not a cliff.

Thursday, November 1, 2012

In today’s edition, economist Dean Baker, Co-director of the Center for Economic and Policy Priorities, on deficit confusion and why “fiscal cliff” is a misleading description of the economic forecast:

1. The budget deficit is not “out of control”.

There is enormous confusion about the nature of the country’s deficit problem. There is a widespread belief that there has been a longstanding problem with large budget deficits.This is simply not true. It is easy to show that the large deficits of recent years are a result of the downturn in the economy following the collapse of the housing bubble.

The budget deficit in 2007 was just 1.2 percent of GDP.

In January of 2008, before it recognized the impact of the collapse of the housing bubble on the economy, the Congressional Budget Office projected that the deficit would remain near 1.0 percent of GDP through 2011.

The deficit was projected to turn to a surplus in 2012 after the expiration of the Bush tax cuts.

The country could run deficits of this size literally forever. The debt to GDP ratio was actually declining.

This situation changed in 2008 because of the downturn caused by the collapse of the housing bubble.

This led to a sharp fall in revenue as taxes fell in response to the fall in output and employment.

It also led to an increase in expenditures for items like unemployment insurance and food stamps.

In addition, there were tax cuts and spending measures taken to directly counteract the downturn, such as the payroll tax cut and the stimulus package.

The combination of automatic stabilizers and deliberate stimulus measures fully explain the large deficits of the last four years.

There were few permanent changes to spending or the tax code that would add to the deficit on an ongoing basis.

If the unemployment rate were to return to the pre-recession level of 4.5 percent and we eliminated the tax and spending measures designed to sustain the economy through the downturn, we would again have modest deficits of a size that could be sustained indefinitely.

2. The “fiscal cliff” is not a cliff at all.

The term “fiscal cliff” and the discussion around this impasse have fundamentally misrepresented the problem facing the budget and the economy. While there have been projections from the Congressional Budget Office and others showing that the tax increases and spending cuts scheduled to go into effect on January 1, 2013 can push the economy back into recession, these projections are showing the impact of failing to reach an agreement by the end of 2013.

The projections assume not only that no deal is reached by January 1, but also that no deal is reached over the course of the year. In other words, we would not be subject to a higher tax rate for a few weeks or a month, these models examined what would happen if we paid taxes at higher rate for a full year and also saw spending cut for the whole year.

As a practical matter, if the end of the year deadline is not met it only means that people will be subject to higher withholding beginning on January 1, 2103. No one would feel anything until they saw their first paycheck of 2013.

Furthermore, if Congress and the president seemed about to reach a deal, which would eliminate much of the tax increase, then most people would be able to anticipate getting back the extra taxes in their next paycheck. In this case, the impact on spending and the economy would be minimal.

There is even less cause to be concerned about the spending side of the cliff.
The sequester applies to appropriations, not actual outlays. Some of the money appropriated in 2013 may not be spent for years into the future.

As a practical matter, there is no reason for the government to do anything to curb spending in January if it appears that a deal is likely to be reached that would lead to levels of spending that are higher than provided for in the sequester.
This means that if Congress and the president take a month or two to work through an alternative to the sequester, the pace of spending need not be affected.

As a practical matter, it is always desirable to reduce unnecessary uncertainty and the resolution of the tax and spending debate creates certainty. But there is no reality to the idea that the end of the year presents a deadline of any consequence. It really doesn’t matter whether a deal is reached on December 28th or January 8th, the impact on the economy will be almost exactly the same.