May 2012

The Sequester and War Spending

An article in The Hill warns that war spending may be in jeopardy because of the sequester. Apparently, the Pentagon has reversed its position on the sequester's application to Overseas Contingency Operation (OCO) spending, now saying that it would be affected. Previously, it had said that the sequester would exempt spending for the war in Afghanistan.

First, it seems that the Budget Control Act does call for war spending to be hit by the sequester, although it is not crystal clear. The defense portion of the automatic cuts applies to function 050, budget code for much of the Department of the Defense (there is also some war spending in the non-defense portion). Although spending on the wars overseas is generally considered separately from the Pentagon's budget, it is lumped into that function; thus, that spending looks like it could be subject to the roughly ten percent cut that will hit defense spending on January 2, 2013.

Still, war spending has an advantage that other defense spending does not: it has no cap on spending. Other discretionary spending will be taken well below scheduled levels since their spending by law cannot exceed certain amounts. War spending, however, can be set at whatever level Congress desires without being out of order in the budget process. Thus, to get around the sequester, lawmakers could simply appropriate money in 2013 above and beyond what they actually want for OCO such that the sequester would bring those levels down to the "desired" amount. For example, if they wanted $80 billion for OCO, they could set a level of $89 billion and allow the level to be automatically brought down to $80 billion.

Of course, this would be a gimmicky way to deal with it, but considering the uncertainty and confusion on the issue, it's not clear how "exempting" or including OCO spending in the sequester would affect the budget.

Dynamic Scoring Explained

What is dynamic scoring? How are legislative proposals currently scored? CRFB's latest policy paper details the process and methods that the Congressional Budget Office (CBO) and Joint Committee on Taxation (JCT) use to estimate the budget impact of legislation and the pros and cons of supplementing that process with "dynamic scoring."

As we explain in the paper, the current process for evaluating legislation does not take into account the effects that legislation could have on macroeconomic variables like GDP or unemployment. However, contrary to what some claim, CBO and JCT do not score on a purely "static" basis, meaning they take no other effects into account. Rather, they incorporate behavioral (or "microeconomic") effects such as shifts in the timing of economic activity, shifts between taxable and nontaxable forms of income, and effects on supply and demand within a specific market.

Incorporating the macroeconomic effects of a proposal into a budget estimate is what is commonly referred to as "dynamic scoring." Dynamic scoring would not only detail how a proposal affected the economy, it would also translate any economic effects into budgetary effects. Although proponents of some policies (especially tax cuts) have occasionally gone as far as to claim that using dynamic scoring would show a deficit-increasing policy would pay for itself, official dynamic estimates have shown these effects to be much more modest than claimed.

There are a number of arguments both for and against dynamic scoring. Proponents state that dynamic scoring provides fuller information about legislation, removes a bias against pro-growth policies, and takes advantage of better technology and economic modeling that has been achieved since CBO was formed in 1974. Detractors state that dynamic scoring would create a large amount of additional work for scorekeepers, would require choosing one model to use for evaluation when no consensus has been achieved about a superior one, would require making assumptions about future policy, and could politicize the scorekeepers who are supposed to be non-partisan and damage their credibility.

We note that it is always better to have more information about legislation, but that it may be practically difficult for dynamic scoring estimates to be incorporated into the official budget process. If Congress does make dynamic estimates more prominent, they should not interfere in the estimates and be willing to live with whatever CBO and JCT produce. Furthermore, as we state:

Importantly, policymakers should be pursuing pro-growth policies regardless of how they are accounted for. In addition to having benefits in its own right, faster economic growth will lead to higher revenue, lower spending on safety net programs, a greater capacity for individuals and businesses to bear tax and spending changes, and a greater capacity of the economy as a whole to carry debt (i.e. higher GDP will lower the debt-to-GDP ratio) – all of which can help the country address its fiscal challenges. Even if scorers do not account for these effects directly, pro-growth policy changes can yield a bonus in the form of lower than projected deficits and debt. Currently, we are faced with making painful choices that, unfortunately, can no longer be avoided. Higher growth will not make painful choices go away, but it will make them relatively less painful.

Click here to read the full paper.

Social Security Disability Insurance Should Not Be Ignored

Brian Faler of Bloomberg has an article about the unwillingness of lawmakers to address Social Security's Disability Insurance program. Although the program's trust fund will run out in only four years (resulting in an automatic 20 percent benefit cut at that time), most people assume that money will simply be transferred from the old-age component of Social Security to fund the shortfall in the disability program. As a result, reforms to make the DI system financially solvent are often overlooked. Still, the looming DI insolvency should be used as an opportunity to make reforms to the Social Security system as a whole.

In recent years, as Faler details, enrollment has exploded due to the recession and it will continue to rise as the baby boomers continue to age and increase their risk of becoming disabled. In addition, eligibility may be difficult to determine -- and may be determined loosely -- due to the subjective nature of some disabilities. Despite the financing issues, the program is also overlooked because of the messy politics. Lawmakers are loathe to do more than tackle outright fraud in the program since cutting benefits can lead to harsh political backlash. 


Source: Social Security Trustees


A month ago, CRFB's Senior Policy Director Marc Goldwein offered a few solutions for the short-term DI problem and urged policymakers to find structural solutions for DI. He noted that:

The Social Security disability system is broken in many ways. Not only is the program financial insolvent, but the system is wrought with fraud, needlessly complex, difficult to navigate, inconsistent and unfair in determining eligibility, inflexible to changes in the structure of the workforce, administratively overburdened, almost completely uncoordinated with other government policies, and unable to help or reward those who are interested in reentering the workforce.

In terms of short-term solutions, Goldwein suggested enhancing anti-fraud efforts, limiting retroactive benefit awards, and eliminating the payroll taxable maximum for the 1.8 percent portion of the payroll tax that is dedicated to DI, among other things. In terms of structural solutions, he suggested that policymakers figure out ways to more clearly define disabilities, coordinate DI with other similar programs, encourage beneficiaries who can do so to return to work, and discourage those can avoid it from entering DI in the first place.

Disability Insurance should not be overlooked in the context of the overall Social Security system. Lawmakers can use the 2016 opportunity to reform the DI system for the better.

A Response to Holtz-Eakin's Four Steps for Tax Reform

Last week, we wrote about American Action Forum president and former CBO director Doug Holtz-Eakin's four steps for tax reform. These involved:

  1. Agree to have a progressive tax system
  2. Agree on a top rate
  3. Agree on a revenue target
  4. Scale back tax expenditures to meet those targets.

At the Committee for Economic Development's Back in the Black blog, Joe Minarik makes a response to those steps. Coming from the perspective that tax reform will have to raise revenue, he suggested that while Holtz-Eakin's steps would get to a workable solution, he would amend them slightly and put them in a different order. His steps are:

  1. Agree on a revenue target for both individual and corporate income taxes.
  2. Agree on a distributional target.
  3. Limit tax expenditures to achieve the best possible tax base.
  4. Set tax rates and other parameters to achieve the prior objectives.
  5. Repeat steps one through four as necessary.

A main difference between Minarik's and Holtz-Eakin's steps is the order of base-broadening and rate-cutting. Minarik argued that by putting the base-broadening step last, Holtz-Eakin opened up the possibility that there would be no way to meet the revenue target. By putting the rate-cutting step last, lawmakers could ensure that the rates and other parameters of the tax system met the targets agreed on.

Finally, on the last point, Minarik noted that the 1986 reform did not come in one fell swoop. It went through seven distinct versions, as he counts it: two by the Reagan Administration, two by the House, two by the Senate, and the final product of the conference committee. Clearly, there will need to be a lot of negotiation involved with overhauling the tax system. But it will surely be impossible to do it if lawmakers don't start trying.

Read the full CED blog post here.

Good News for a Deal?

A Washington Post article late last week detailed a number of current Republican members of Congress or Congressional candidates who are foregoing the "no new taxes" pledge circulated by Americans for Tax Reform. Signs that the seemingly ubiquitous pledge is fading in popularity are good for the purpose of getting a deal on deficit reduction that tackles all parts of the budget. Here's one example of a House candidate eschewing the pledge:

In Pennsylvania, Republican state Rep. Scott Perry said he was disappointed to see his party’s presidential candidates — all but one of whom signed the pledge — uniformly indicate in a debate last year that they would reject a deficit reduction deal that paired $1 in revenue increases for every $10 in spending cuts.

"I just think it’s imprudent to hem yourself in where you can’t make a good agreement that overall supports the things you want to do," said Perry, who said he generally opposes tax increases but recently won a Republican primary in a conservative district over candidates who had signed the pledge. "I just don’t see what the point of signing would be for me. . . . I’ve got a record, and everyone who wants to know where I’ve been and where I’m at can look to that."

A Massachusetts House candidate also was quoted as saying, "If there’s a loophole that can be closed that ends up generating additional revenue that can be used specifically to pay down the national debt, I’m not going to lose sleep. And I don’t want to be bound by the pledge not to close it." Certainly, it is positive to hear a candidate talking about looking at the merits of tax expenditures, rather than the revenue impact of limiting them.

Last year saw a symbolic victory over the pledge when a bill to eliminate an ethanol tax credit passed by an overwhelming majority in the Senate. As we said at the time:

The tension among conservatives over whether to defend tax expenditures has been great in the past few months, with observers wondering whether Republicans in Congress would support cutting them or side with Norquist and the no-new-taxes pledge. In this case, Senate Republicans have overwhelmingly sided with the former group, recognizing that tax expenditures are merely spending through the tax code. This opens the door to meaningful tax reform that could be part of a budget deal, and that is all around great news.

Everything will need to be on the table with regards to deficit reduction; in particular, we will need revenue increases in any bipartisan plan to get our debt back on a sustainable path. As former Sen. Alan Simpson said at the 2012 Peterson Fiscal Summit, "The only thing [Norquist] can do to you is defeat you for re-election or put some dud into your primary to take you out, and if that means more to you than your country, you shouldn't even be in Congress."

Fiscal Fact Checker: How Much Has Spending Increased Under President Obama?

Update: The text has been updated to include spending growth numbers for President Bush excluding financial rescue programs.

An article by Rex Nutting on MarketWatch claiming the "Obama spending binge never happened" lit up publications across the Internet last week. Nutting claims that spending under President Obama has only increased at 1.4 percent annually in his first term (through FY 2013), lower than any president since Dwight Eisenhower. Not surprisingly, numerous disputes have arisen over the methodology, who deserves blame for what, what measures should be used, and what the article means. Even two main fact checkers, Politifact and the Washington Post's Glenn Kessler, are split on the claim's accuracy.

Overall, we think Nutting's methodology is technically accurate, but the numbers are somewhat misleading. There are myriad ways to break down the numbers, which we discuss below.

To check the claim, we have produced our own numbers by presidency going back to the Kennedy Administration, measuring annual spending growth in a number of ways. They are:

  • Nominal growth of total spending
  • Inflation-adjusted (real) growth of total spending
  • GDP-adjusted growth of total spending
  • Real growth of primary (non-interest spending)
  • Real growth of total spending excluding automatic stabilizers
Annual Spending Growth by Administration
  Total Spending Primary Spending Non-Stabilizer Spending
Administration Nominal Growth Real Growth GDP-Adjusted Growth Real Growth Real Growth
Kennedy/Johnson 8.2% 5.4% 0.6% 4.4% 5.6%
Nixon/Ford 10.5% 3.8% 0.9% 3.8% 3.4%
Carter 14.1% 2.8% 2.3% 2.7% -1.1%
Reagan 6.5% 2.6% -0.8% 0.6% 2.7%
Bush I 5.4% 1.5% 0.3% -2.3% 1.4%
Clinton 3.5% 0.9% -2.0% -0.6% 0.9%
Bush II 7.8% 5.2% 3.7% 4.5% 5.0%
Obama* 2.4% 0.3% -0.9% -1.4% -0.2%

Sources: CBO, OMB, Bureau of Labor Statistics, CRFB calculations
*Uses President's budget spending for FY 2012 and 2013

In terms of nominal and real total spending growth, the measures that Nutting used, President Obama does have the lowest growth of any president since the Eisenhower Administration. Our growth numbers are somewhat higher than his, though, due to our use of President's budget spending for FY 2012 and FY 2013. In the three other measures, the President comes in at the second lowest growth mark.

One point of controversy in the MarketWatch article is that he assigns the FY 2009 spending level largely to President Bush, since much of the budget was already determined before the presidency changed hands and a lot of the 2009 spending increase was due to automatic stabilizers in the budget increasing as the economy deteriorated in late 2008 and through 2009. Of course, there is some spending -- the 2009 stimulus, the Children's Health Insurance Program (CHIP) reauthorization, and the March 2009 continuing resolution -- that President Obama initiated that had effects in 2009, which Nutting appropriately assigns to him in 2010. Then he measures the increase from 2009 to 2013.

Assigning this spending to 2010 does help make the numbers more fair, but it doesn't correct for all of the problems. Perhaps most significantly, certain financial programs -- the Troubled Asset Relief Program (TARP), the takeover of Fannie Mae and Freddie Mac, and FDIC efforts to help banks -- registered more than $250 billion of spending in 2008 and 2009, but those have since tapered off to about $10 billion. These programs are charged to President Bush, which makes sense since he passed TARP and the Fannie/Freddie conservatorship, but they are also built into President Obama’s "base" so that he gets credits as these programs naturally unwind. Excluding these three programs yields somewhat higher spending growth, annualized at 4.5 percent (or 2.5 percent after adjusting for inflation). Spending growth rates of that size would no longer give Obama the lowest growth rates.

Spending Under President Obama Excluding Financial Programs (billions)
  2009* 2010* 2011 2012^ 2013^ 2009-2013 Annual Growth
Nominal Outlays $3,112 $3,692 $3,639 $3,594 $3,708 4.5%
Outlays in 2009 Dollars $3,112 $3,659 $3,483 $3,437 $3,423 2.5%

Source: CBO
*Obama spending initiatives with costs in 2009 are shifted to 2010
^Reflects President's budget spending

One could also do the same for President Bush. However, one could assign the 2009 spending for the Fannie/Freddie conservatorship to President Bush, since it did pass during his presidency. If you include Fannie/Freddie but exclude TARP and the FDIC, the nominal and inflation-adjusted growth rates would be 7 and 4.5 percent, respectively. If you exclude Fannie/Freddie as well, doing the same thing as was done for President Obama above, the nominal and real growth rates would be 6.7 and 4.1 percent, respectively.

Some conservatives have argued (see here for example) that measures of spending growth are much less relevant than the levels of actual spending. Even if President Obama came into office at a time when spending was set to swell due to the recession, he kept those inflated levels of spending throughout the budget. To some extent, that is true. Although spending will continue declining as a percent of the economy after the economy recovers, it will never get down to pre-2009 levels. The Affordable Care Act is the main Obama-specific factor that permanently raises spending over the longer term. Still, there are also demographic factors that will automatically push spending up above their historical levels.

In short, Nutting's article may be technically accurate from one perspective on how much spending growth there has been under President Obama, but it likely understates that amount by including the reductions that automatically occurred in financial crisis-related programs such as TARP.

Overall, though, the article and the ensuing controversy miss the bigger point. Assigning blame or credit to presidents ignores the fact that they must work with an entire Congress to pass legislation. In addition, their budgets can be significantly affected by the decisions of previous Congresses and presidents. The blame game is much less important than trying to find a bipartisan solution to our budget problems.

Minnesotan Praise for "Debate the Debt"

CRFB has called for this year’s presidential candidates to "Debate the Debt" by dedicating one of the three presidential debates to proposals for putting the federal debt on a sustainable path. More and more Americans, from all walks of life, are joining the call.

Today’s St. Paul Pioneer Press features an op-ed by Williston Group President Chuck Slocum, who urges the candidates to debate the debt and who praises CRFB and in particular three Minnesotan veterans of Congress for their efforts for fiscal responsibility and sustainability – CRFB Co-Chairs Bill Frenzel and Tim Penny along with a third CRFB Board member, former Rep. Martin Sabo.

What concerns Frenzel, Penny and Sabo is that the nation is now borrowing 40 cents of every dollar spent and that what they call "a $7 trillion fiscal cliff" is looming at the end of the 2012. They and others at CRFB believe that the nation's debt is on "an unsustainable path" and that the American electorate must better understand the situation prior to selecting its president on November 6.

At the proposed debate, each presidential candidate would present and defend his own plan to achieve the amount of savings needed to stabilize the national debt as a percentage of GDP. A skilled moderator would lead the candidates through a discussion of their spending and revenue proposals. The plans could be scored by outside experts ahead of the debates so the televised discussion "wouldn't get bogged down with accusations of inaccurate math," the CRFB suggested.

Please join all of us and sign the petition for candidates to Debate the Debt!


The Wrong Fight on Taxes

The Hill has an article today detailing infighting within the Democrats over what to do with the 2001/2003 tax cuts. The position expressed by President Obama and many Democrats for years has been to extend the tax cuts only for people making less than $250,000, but a growing contingent seems to favor upping that threshold to $1 million, including House Minority Leader Nancy Pelosi (D-CA). Luckily, there has already been some pushback to this idea (see here, here, and here).

The $250,000 definition for the middle class is already higher than it should be, accounting for about 80 percent of the cost of the $4.6 trillion tax cuts. In other words, letting the upper-income tax cuts expire will result in foregone revenue loss of about $900 billion. A rough estimate of moving that threshold from $250,000 to $1 million would result in only about $400 billion of that $900 billion being realized, meaning that about 90 percent of the total costs of extending all the tax cuts would be added to the debt.

It would be bad news for our fiscal situation if the negotiation over the tax cuts will simply be about deficit financing either $4 trillion or $4.6 trillion. Neither party is taking a responsible position on taxes, and it will lead us into trouble. Our fiscal hole is very deep if we extend all the tax cuts, and it wouldn't get much shallower at the $250,000 threshold. At a $1 million threshold, it would barely make a difference.

Note: Tax cuts extended below $1M is a rough estimate 

In addition, the framework of extending tax cuts at a certain income level misses the point. Having distributional goals makes sense, but drawing strict lines in the sand will ultimately do more harm than good. A better focus would be on improving the tax code with an eye towards the distribution and revenue levels that are desired.

The Simpson-Bowles tax reform plan did just that, raising revenue from tax reform while ending up with a more progressive tax code (see here for a distributional table of Simpson-Bowles). It won't be easy to achieve a reform plan that does this, but it would be much more constructive to this kind of debate than to fight about whether we will extend 80 percent, 90 percent, or 100 percent of the tax cuts. We will need to get significant revenue as part of a deficit reduction plan, but the rhetoric from both sides so far is not promising.

Good News on the Fiscal Cliff?

Each day the Fiscal Cliff gets closer and closer, adding more uncertainty to our economic situation. But, as Deutsche Borse Group reports today, there is some cause for hope. With the Congressional Budget Office (CBO) having released a report giving lawmakers an estimate as to what would happen if the all the policies scheduled to happen at year end would occur, there is news that there has been ongoing discussions and negotiations behind the scenes to get the job done - and better yet, to do so by enacting a full, comprehensive fiscal plan.

To recap, the fiscal cliff is the expiration of a slew of policies, and the sequestration being activated, with the added bonus of needing to raise the debt ceiling. These policies combined, according to CBO would put the US economy into a double-dip recession for the first half of next year by having growth equal to negative 1.3 percent, but over the full year, would equal a still lackluster 0.5 percent. 

As we have explained previously, and as CRFB president Maya MacGuineas recently explained, "Instead of going over the fiscal cliff or allowing an ever growing mountain of debt, we should rise to the challenge and enact a comprehensive plan with more targeted and thoughtfully crafted measures."

Thankfully, some are doing just that. As Senate Budget Committee Chairman Kent Conrad said, "Things are pretty quiet on the surface up here (in Congress), but beneath the surface there is a lot of careful, detailed and intense working occurring on a deficit reduction package, involving people from both parties."

The article continues:

 "I think we all know the kind of plan we need to pass and pass very soon. But I can't tell you that there is sufficient support up here to pass it now. The mood must change. But things do change. Events happen. The situation in Europe worsens. We want to be ready if there is an opportunity," Conrad said.

Conrad said he is working with lawmakers both within the Senate Budget Committee and in informal groups such as the "Gang of Six" to develop a deficit reduction package.

"This is incredibly detailed, difficult work. It takes months and months of careful preparation to be ready with a plan. Some of us are determined to be ready pretty soon with a plan. We hope the political moment comes that allows us to move the package," he said.

"Both parties must move together on this. That's the only way it can happen," he said.

We hope this news leads to something real - the Fiscal Cliff is approaching and we need to act on it.


USA Today Accounts for Unfunded Liabilities

The USA Today has an interesting article on the "real federal deficit" for 2011. They say that the $1.3 trillion is dwarfed by a more comprehensive tally that includes changes in unfunded liabilities:

The big difference between the official deficit and standard accounting: Congress exempts itself from including the cost of promised retirement benefits. Yet companies, states and local governments must include retirement commitments in financial statements, as required by federal law and private boards that set accounting rules.

The deficit was $5 trillion last year under those rules. The official number was $1.3 trillion. Liabilities for Social Security, Medicare and other retirement programs rose by $3.7 trillion in 2011, according to government actuaries, but the amount was not registered on the government's books.

In addition, for 2010, when the deficit number was similar to 2011, the accrual accounting deficit was much higher at $5.6 trillion.

Read the full USA Today piece here.

How to Make a Deal, Tax Reform Edition

In a blog post cross-posted at Tax Policy Center and Forbes, Howard Gleckman summarizes a talk that American Action Forum president and former CBO director Doug Holtz-Eakin made at a National Tax Association conference last week. Holtz-Eakin laid out four simple--or not so simple--steps to getting tax reform. As Gleckman summarizes, they are:

1. Recognize that the U.S. will have a progressive tax code (the flat tax, he said, is, “naïve”).

2. Agree on a top rate.

3. Agree on how much revenue you want to raise.

4. Eliminate or scale back the tax preferences you need to accomplish the first three.

Easy-peezy, as they say.

Gleckman says that agreeing on number one should be easy since the political consensus is there--not to say there aren't flat tax/consumption tax proponents out there. He rightly points out that number three is the key to a deal and the most difficult obstacle. The revenue target, however, has been an ongoing argument for a few years that has gone nowhere, which by default has meant that our revenue path has not been changed.

Agreeing how much revenue the government should raise as a percent of GDP is a much better way of targeting revenue rather than targeting the change from a baseline. It removes the games that have only gotten more complicated in a recent years as the number of temporary tax provisions has continued to rise and cloud the baseline. Also, it more explicitly links the process of collecting taxes to the size of government that is collectively desired. That's the point of taxes in the first place--to fund government.

Once policymakers agree on a revenue target and a top rate, Gleckman says, the politics becomes much easier.

The last step in Doug’s roadmap is figuring out how to pay for reform. And, oddly perhaps, that might be the easiest bit of all. As Ronald Reagan, Dan Rostenkowski, and Bob Packwood learned in 1986, once the leadership agrees on a rate and a revenue number, it is very hard for the lobbying class to fully protect its clients’ interests.

Tax reform is by no means simple. Even beyond the politics, there are a number of complex and technical issues that must be considered when overhauling the tax code. Still, lawmakers can make it easier on themselves by setting their goals ahead of time and working towards a system they can agree on that meets those goals.

Of course, if agreeing on goals were that easy, we wouldn't be in this position.

CBO Joins the Cliff Estimating Game

Estimates of the fiscal cliff that is set to occur at the end of the year have been popping up in recent weeks. Now CBO has lended its voice to the discussion in a brief, making a number of interesting observations and quantifications with regards to the cliff.

The brief first notes that under current law, deficits are set to decline by $560 billion from FY 2012 to FY 2013 ($1.17 trillion to $610 billion). That total is the sum of $607 billion of gross deficit reduction netted against $47 billion of budgetary effects from the negative economic impact of the cliff. This deficit reduction includes $500 billion of policy changes: the expiration of the 2001/2003 tax cuts, the patching of the Alternative Minimum Tax (AMT), the implementation of the sequester, the expiration of the payroll tax cut and extended unemployment benefits, the implementation of taxes in the Affordable Care Act, and the 30 percent scheduled reduction in Medicare physician payments. Another $100 billion of deficit reduction comes from general fiscal improvement. 

Sources of Change in Deficits from FY 2012 to FY 2013 (billions)
FY 2012 Deficit -$1,171
2001/2003 Tax Cuts and AMT Patch $221
Payroll Tax Cut $95
Tax Extenders $65
ACA Taxes $18
Sequester $65
Unemployment Benefits $26
Physician Payments ("Doc Fix") $11
Non-Policy Related Changes $105
Economic Feedback Effects -$47
FY 2013 Deficit -$612

Source: CBO

Notably, CBO's previous economic outlook in January did not account for the payroll tax cut, unemployment benefits, and doc fix, which had only been extended through February rather than through the end of the year. Accounting for this change boosts their estimate of 2012 growth by 0.6 percentage points (to around 2.7 percent), but reduces 2013 growth by a similar amount to 0.5 percent. This includes a 1.3 percent contraction in the 4th quarter of 2012 and the 1st quarter of 2013, which leads CBO to conclude that this period would likely qualify as a recession. In addition, the anticipatory effects of the cliff could hurt growth by somewhere in the neighborhood of 0.5 percentage points in the second half of 2012.

They also evaluated alternative scenarios for 2013. Under a scenario of literally zero fiscal restraint--in other words, the deficit as a percent of GDP in 2013 is the same as in 2012--FY 2013 growth would be somewhere between 1.4 percent and 7.3 percent, with a central estimate of 4.4 percent. In addition, the policy would boost employment by between 600,000 and 3.4 million people, with a central estimate of two million. Obviously, this policy would be helpful strictly in the short term but would require a run-up in deficits even beyond averting the entire fiscal cliff; in other words, it would require offsetting automatic stabilizers that would automatically reduce the deficit as the economy continues to grow.

Under CBO's Alternative Fiscal Scenario, the fiscal cliff is averted with the exception of the payroll tax cut, unemployment benefits, and ACA taxes, but there is still some fiscal restraint as the deficit falls from 7.7 percent of GDP in 2012 to 6.3 percent in 2013. Growth in 2013 is somewhere between 0.8 percent and 3.4 percent, with a central estimate of 2.1 percent, while employment is between 400,000 and 2.3 million greater, with a central estimate of 1.3 million.

Economic Effects in FY 2013 of Different Fiscal Scenarios
  Real GDP Growth Change in Employment (millions)
Current Law 0.5% N/A
Zero Fiscal Restraint 1.4% to 7.3% 0.6 to 3.4
Alternative Fiscal Scenario 0.8% to 3.4% 0.4 to 2.3

Source: CBO

Although the alternate scenarios help with growth in the short term, CBO notes that these scenarios would be bad for the economy in the longer term. The AFS would run up debt to 93 percent of GDP in 2022, 30 percentage points higher than under current law. This level of debt with the economy at full capacity would crowd out private investment, would overwhelm the positive effects of extending the policies, and would limit the ability of policymakers to respond to emergencies or recessions--that is, of course, not even mentioning the increased risk of a fiscal crisis. It is less clear what the "zero fiscal restraint" scenario would do in the longer term, since it would depend on what policy prescription was followed beyond 2013.

What's the right path? Take it away, CBO:

In particular, if policymakers wanted to minimize the short-run costs of narrowing the deficit very quickly while also minimizing the longer-run costs of allowing large deficits to persist, they could enact a combination of policies: changes in taxes and spending that would widen the deficit in 2013 relative to what would occur under current law but that would reduce deficits later in the decade relative to what would occur if current policies were extended for a prolonged period...

That approach to fiscal policy would work best if the future policy changes were sufficiently specific and widely supported so that households, businesses, state and local governments, and participants in the financial markets believed that the future fiscal restraint would truly take effect. If such policy changes were enacted soon, they would tend to boost output and employment in the next few years by holding down interest rates and by reducing uncertainty and enhancing business and consumer confidence. Moreover, enacting policy changes soon would allow for implementing them gradually while still limiting further increases in federal debt and the corresponding negative consequences. Therefore, although there are trade-offs in choosing when policy changes to reduce future deficits should take effect, there are important benefits and few apparent costs from deciding quickly what those changes will be.