In evaluating the fiscal cliff, it is interesting to see how it compares to past cases where the federal government has rapidly reduced deficits. The OMB has historical data on deficits as a percent of GDP going back to 1930, so we can evaluate based on this time period. For simplicity's sake, we will compare "cliffs" by the change in deficits from the previous year. Obviously, this isn't a perfect method since it does not account for fiscal improvements due to the economy, but it does put the cliff in some historical context.
The fiscal cliff will reduce deficits from 7.6 percent of GDP in FY 2012 to 3.8 percent in FY 2013, a 3.8 percent cliff. No period in recent decades comes close to the size of the cliff. To find something comparable, one must go back to 1968-1969. Here's a look at three notable fiscal consolidation efforts that the US has undertaken:
- 1937: In 1936, the deficit stood at 5.5 percent of GDP, with revenue and outlays at 5 and 10.5 percent, respectively. FY 1937 brought a cliff of 3 percent of GDP -- slightly smaller than the current fiscal cliff -- as the deficit fell to 2.5 percent. Among other things, 1937 was the first year that the Social Security payroll tax was collected, although it only comprised one-tenth of that year's cliff. Some economists blame the fiscal consolidation in 1936-1937 for bringing on the double dip recession that occurred in 1937-1938.
- World War II: Not surprisingly, the post-World War II drawdown is the largest "fiscal cliff" in the years where data are available. During the war, spending surged to an all-time high of about 44 percent of GDP. The first "cliff" actually occurred before the war ended as tax increases enacted in 1943 brought the deficit down by 7.6 percentage points of GDP between FY 1943 and FY 1944. The bigger cliff came after the war as the deficit fell from 21.5 percent of GDP to 7.2 percent between 1945 and 1946, a fall of over 14 percentage points. Two years later, the government had a surplus of 4.6 percent of GDP, meaning that the drawdown from the war had turned the fiscal situation around by 26 percentage points of GDP in only three years -- even with tax cuts being enacted in 1945.
- 1968: In 1968, Congress passed and President Johnson signed the Revenue and Expenditure Control Act, which most notably slapped a ten percent surtax on individuals and corporations. This surge in revenue, probably aided by growth, turned a 2.9 percent of GDP deficit into a 0.3 percent of GDP surplus between 1968 and 1969. This turnaround is the largest cliff post-WWII and produced the last budget surplus until the 1990s. However, some economists blame this quick consolidation for causing the 1969-1970 recession.
If it were allowed to happen, the fiscal cliff would represent the largest fiscal consolidation in a single year since the drawdown after World War II. These past cliffs were followed closely by recessions, so we must learn from history and replace the coming fiscal cliff with a smart and gradual debt reduction plan.