Fiscal cliff is decades off, but Congress should act

Never let it be said that the financial community has a deaf ear for language. The same folks who saw “green shoots” after the “soft patch” are now focusing their collective attention on the “fiscal cliff.” For those unfamiliar with this topographical reference, the fiscal cliff refers not to a physical precipice but to the metaphorical one off which the U.S. economy will fall at the start of 2013 unless Congress acts. An array of tax cuts and transfer payments are scheduled to expire on or about Jan. 1. Among them, the lower marginal income, capital-gains and dividend tax rates, enacted under President George W. Bush and already extended twice; the 2-percentage-point reduction in the employee portion of the payroll tax; and extended unemployment benefits. At the same time, an automatic $1.2 trillion cut in discretionary spending (both defense and non-defense), as dictated by the Budget Control Act of 2011, will kick in because the supercommittee appointed to find such savings punted. All told, it’s being advertised as something akin to, well, a “100-year flood.” By some estimates, the combined force of these tax and spending measures will slash several percentage points off growth in 2013 and 2014.

Not everyone is buying that. Stephen Stanley, chief economist at Pierpont Securities, says a share of the fiscal-cliff-hanging is based on a flawed Keynesian perspective that “all austerity is bad for the economy.”

Under current law, the Congressional Budget Office projects a 2013 federal deficit of $585 billion following four years of trillion-dollar shortfalls. That would shrink federal spending to 22.5 percent of gross domestic product, well above the historical average of about 19.5 percent. To Keynesians, a half-trillion dollars of government spending may look inadequate to support economic growth. To followers of Milton Friedman, it’s resources freed up to be used more efficiently by the private sector. As for the $1.2 trillion sequestration, it is over a 10-year period and isn’t really a cut. It’s merely a reduction in the projected growth of spending. Stanley says he “isn’t losing sleep over the prospect of modest spending cuts in 2013.”

Those who are should forget modelbased forecasts using a large spending multiplier. What we care about are the real-world effects. If there were little or no impact from government initiatives, it’s hard to argue their reversal will send the economy over the cliff.

Stanford University economist John Taylor has looked at the data on the $831 billion fiscal stimulus enacted under President Barack Obama in 2009 and found little evidence that the “temporary and targeted Keynesian packages” of increased government spending, transfer payments and tax rebates helped the economy or increased growth in any significant or sustained way. No surprise. That’s what Friedman and Franco Modigliani taught us. People make spending and saving decisions based on their expected income over a lifetime.

State and local governments used their grants from the 2009 fiscal stimulus to reduce borrowing and increase transfer payments, not invest in infrastructure, according to Taylor. Ditto the federal government, which boosted infrastructure investment by 0.05 percent of GDP and consumption by 0.14 percent in the peak quarter. Taylor gives a similar thumbs-down to Bush’s 2001 and 2008 tax rebates, which raised disposable personal income without much parallel increase in spending. Obama’s payroll tax “holiday” yielded minimal results, as well.

More worrisome than the modest reduction in the growth of spending, should it ever transpire, is the expiration of the Bush tax cuts. The reduction in marginal income-tax rates to 35 percent from 39.6 percent and in the rate on capital gains and dividends to 15 percent for top earners, coincided with a period of unimpressive growth for the U.S. economy. Perhaps the increase won’t cause too much damage. After all, marginal tax rates affect labor supply over a lifetime, not necessarily in the short run, according to Nobel laureate Edward Prescott.

Taylor, for one, thinks the Bush tax cuts, if allowed to expire, will have a significant impact — in large part because they will be viewed as permanent. (Kind of like the Bush tax cuts?)

At least the direction, not the magnitude, is permanent. Unless Congress gets serious about structural tax reform — about increasing revenues by closing loopholes and lowering rates — income-tax rates are headed much higher. The Social Security Trustees report this week was another reminder that the clock is ticking on entitlement reform. Last year, benefits paid to retirees exceeded non-interest income for the second consecutive year. The cashflow deficit will continue through the 75-year forecast period, according to the program’s trustees. The trust fund will be exhausted by 2033, three years earlier than projected a year ago.

Talk about a fiscal cliff. Twenty years may be too long a period to inspire our short-term-oriented lawmakers to action. But if you want to worry about a looming rock formation, it should be the one in 2033, not 2013.