Deficit Reduction Helps the Economy, But It Isn't Just a Counting Exercise

CBO recently released its analysis of a hypothetical deficit reduction plan's effect on the economy. They use a $2.4 trillion deficit reduction plan (about the same as the hypothetical Biden group plan) to illustrate the short-term and long-term economic effects of fiscal consolidation, while showing how these effects either add to or detract from the original deficit reduction.

Their analysis states that the immediate short-term effects of a deficit reduction plan would reduce real GNP by between 0.3 and 0.6 percentage points in 2012, assuming $100 billion of savings in that year. However, by 2021, the plan increases real GNP by 0.6 to 1.4 percentage points, and it has an overall positive effect on the economy in every year after 2015. This improvement is due to the decrease in interest rates that the deficit reduction causes.

Because the effect of the plan is more positive on the economy within the ten-year window, the original $2.4 trillion of savings is enhanced by an additional $200 billion. The table below shows both the original deficit reduction and the additional savings from potential dynamic effects of the plan on the economy (assuming "medium-sized" effects).

CBO does have some caveats for its estimate. For one, a deficit reduction plan of the same size could time its cuts much differently. For example, a plan that cuts less in the first few years and backloads the savings more or provides a temporary stimulus upfront would have less of a negative short-term impact or possibly a positive one. The latter option is an example of the "walk and chew gum" approach that many people have talked about in the past year: stimulus in the short term, coupled with a longer-term deficit reduction plan.

Another caveat CBO outlines is the plan they use is a generic deficit reduction plan. CBO assumed its plan would have no effects on labor supply, business incentives, or long-run productivity; that is, the plan would not effect marginal tax rates, depreciation schedules, unemployment insurance, or government spending on education and infrastructure. Any plan that alters these variables in a positive direction--for example, by lowering marginal tax rates or spending more on infrastructure--could have an even greater economic effect.

Yet, even if their dynamic analysis doesn't hold true for all fiscal plans, it shows the positive effect that deficit reduction alone can have on the economy in the medium-term. If we design a plan the right way, the positive long-run effects could be magnified further.