Newsroom & Financials

CoBank News Feed

July Outlook

The Looming Fiscal Cliff

 At the end of 2012, two events are scheduled to occur that many fear will deliver a real shock to the fragile U.S. economy. One is the expiration of the Bush-era tax cuts, which will increase income, dividend, estate and capital gains tax rates for a substantial majority of American taxpayers. The other is mandatory cuts to domestic and military spending programs that were agreed to as part of the congressional debt-ceiling negotiations last year.

The combination of spending cuts and tax hikes will remove an estimated $600 billion from the U.S. economy in the first year alone. The only way to avoid this economic double-whammy – the so-called “fiscal cliff” – will be a bipartisan agreement in Washington, D.C. Whether that’s possible in the middle of a presidential election year remains to be seen.

For background on the issue, OUTLOOK talked recently with Kevin A. Hassett an economist with the American Enterprise Institute. Hassett, who is also a columnist for the National Review and an advisor to Republican presidential candidate Mitt Romney, believes the nation could be in for a rough ride if the fiscal cliff isn’t averted.

OUTLOOK: We hear a lot of talk these days about a “fiscal cliff” approaching. What does it refer to?

Kevin Hassett: The fiscal cliff is coming at the end of this year, when all of the tax cuts that have been enacted basically going back to President Bush’s first term will sunset. What that means is there will be big, big tax increases for everybody. And at the same time there will be a large reduction in government spending that was agreed to as part of the debt deal last year. All of those factors are giving a lot of people pause because tax hikes are a negative stimulus and government spending reductions are a negative stimulus.

OUTLOOK: How big will the tax hikes be? Who will be affected?

KH: Nearly every taxpayer will be affected. The expiration of a two-year tax cut extension passed in 2010 will lead to an increase in the marginal tax rates in all income brackets: the lowest bracket will go from the current 10 percent to 15 percent; the current 25-percent bracket will increase to 28 percent; the current 28-percent bracket will be replaced with a 31-percent bracket; the 33-percent bracket will increase to 36 percent; and the current top bracket of 35 percent will be replaced with a top bracket rate of 39.6 percent.

Another hit to workers will be the expiration of a temporary payroll tax reduction that Congress passed in 2010.

Capital gains and dividend taxes will go up for most Americans, as well. Currently, the maximum federal rate on long-term capital gains and dividends is 15 percent, but this is set to increase to 20 percent, with the top tax on dividends set to increase to 39.6 percent. Workers in the lowest two tax brackets currently pay no taxes on dividends or capital gains, but with the expiration of these rates, they will pay 10 percent on capital gains and 15 percent on dividends for the lowest bracket, and 28 percent on dividends for the second lowest bracket of income earners.

Other tax increases include a higher estate tax and the end of an estate tax exemption for properties between $3.5 million and $5 million; the end of a patch on the Alternative Minimum Tax; and the end of tax rates for married couples which eliminated the “marriage penalty” on couples filing jointly.

In total, revenues are expected to go up by $494 billion next year if all of these tax changes occur.

OUTLOOK: Are corporate taxes affected by the expiration of the Bush tax cuts?

Corporate tax rates are not directly affected by the expiration, except in the expiration of some provisions allowing for businesses to fully expense investments in capital. That was part of the 2010 compromise legislation allowing an extension of the Bush-era tax cuts. However, the expiration of the Bush tax cuts will have a big impact on the many small businesses that pay taxes through the individual tax code.

OUTLOOK: You’ve written that we should fundamentally reform our corporate tax structure.

KH: That’s another big negative right now. The easiest way to see how crazy U.S. policy is that, other than the Republic of the Congo and Guyana, we have the highest corporate tax on Earth, and at the same time our corporate tax revenue as a percent of GDP is the lowest it has ever been. So we’ve got the most punitive high tax and the least revenue we’ve ever had. And the reason we’re in first place among developed nations is because everyone else has recognized that capital income is mobile and if you have a high rate then capital income will run to a different place. And this is one of the things we’ll have to fix if we want to generate positive growth that is better than 1 percent or so because right now wealthy multinationals are reluctant to locate new plants in the United States given the punitive taxes that we have.

In the current system if a U.S. multinational makes some money in Ireland it won’t pay U.S. tax until it mails the money home. But because Ireland has such a low corporate tax rate, about 10 percent, there’s a strong incentive to locate your profits in Ireland. So what that means is that if the multinational locates a lot of activity in Ireland then it can have its U.S. parent buy a lot of stuff from its subsidiary in Ireland and pay exorbitantly high prices for these things and the result will be very little profit in the U.S. but lots and lots of profit in Ireland. And those games are part of the U.S. tax code.

Blue collar workers should be rioting right now in favor of lower corporate rates because they’re the ones who would benefit. Factories tend to get built in countries with lower rates and those factories bid up salaries for blue-collar workers.


OUTLOOK: Talk about the scale of the spending cuts and where they will occur.

KH: Beginning in 2013, parts of the Budget Control Act passed in 2011 will take effect, creating caps in spending for certain programs that will total $1 trillion between 2013 and 2021. In 2013, $54.7 billion in cuts will come from discretionary programs and entitlement programs, including some cuts in payments to providers in the Medicare program, farm price supports, and student loans, along with proportional cuts in discretionary programs. Another $54.7 billion will come from defense programs, including proportional decreases in many programs with the exception of war spending, which is effectively exempt from cuts.

After 2013, the same amount of money will come from statutory caps on defense and discretionary spending, but in contrast to 2013, the cuts won’t necessarily be proportionally distributed. While equal amounts will come from defense and discretionary spending, the Appropriations committees can distribute cuts in whatever fashion they decide upon, except for mandated cuts in entitlement spending which will continue from 2013.

OUTLOOK: Which will have the bigger impact, the tax hikes or the spending cuts?

KH: People can argue which one will have the bigger effect but if you’re doing both then it should arouse anxiety on the part of everyone. On top of all this there is likely to be the need for another debt limit increase at about that time.

So pretty much every single possible fiscal variable is going to be in play in December with a lame duck Congress. 

OUTLOOK: How do the debt ceiling negotiations affect the picture? 

KH: Congress sets the total amount of government debt that we can have and when we run deficits then over time we get close to the limit. If we’re going to be able to borrow again then Congress has to pass an increase in the limit. And if Congress doesn’t it can put a significant constraint on what government can do. Ultimately it won’t even be able to write checks.

If you go back and look at the data last summer when we had the debt limit debate in Congress there was a lot of anxiety that maybe Republicans would not raise the limit and then the government would have to shut down. It’s pretty clear that the anxiety was a big negative for the economy. I’m not saying that it was a worse negative than for the nation to go bankrupt, which could happen if we don’t try to get ahead of the curve on spending. But the fact is some economists at the University of Chicago estimated that the debt limit debate last year probably cut 1.5 percent off GDP growth. This year we’ve got another debt limit showdown and it’s going to happen at the same time when virtually everything else is up in the air as well. So if you think last summer’s debt limit debate was bad for the economy then you should be even more concerned this year.

OUTLOOK: How does anxiety reduce growth? Because investors keep their powder dry?

KH: Exactly. If you don’t know what the rules are going to be it’s hard to do the math to justify a capital investment. Consider even the example of government workers. If they’re anxious about not getting their checks then maybe they don’t buy automobiles. The private sector is affected too. When people don’t know what the rules of the game are they simply put off making decisions until the rules are defined. We are going to be in a period between now and December when there is extreme uncertainty about what’s going to happen next.

OUTLOOK: What should Congress do to eliminate the uncertainty? Can we avoid the fiscal cliff?

KH: We need to recognize that in an election year it’s almost impossible to do anything between now and November. And whoever wins is going to have a very strong incentive in the lame-duck session to push decisions into the next Congress. So if it were me, especially since the economy is perched so close to the edge, what I would do is pass an extension right away. I would extend all of the Bush tax cuts and the payroll tax cut and suspend the spending cuts into the summer of next year. That way, the new Congress and the new president, or the existing president with a new Congress, will have a good chunk of time to finally get a grip on these things.

OUTLOOK: Is a compromise likely or unlikely to occur in your view?

KH: The lame duck session will almost surely be able to kick all of these problems into next year. Whether a long-term fix or another short-term patch is pursued by the next Congress will, of course, depend on the election. To the extent that power is divided approximately evenly, it may be difficult to aim high.

OUTLOOK: When Congress does get around to addressing these issues for the long term, what should it do?

KH: What Congress needs to do is to sort of start from scratch rather than playing small ball. I was at an event with President Bush a couple of months ago in New York and he said he wished they weren’t called the Bush tax cuts because that means automatically there are a lot of people who hate them even though normally they might be disposed to like them. So we need to start over and seek common ground by broadening the base and lowering the tax rates and putting entitlements on a more sustainable path by making some tough long run decisions. To the extent that you do that, you just call it sound, bipartisan policy.

OUTLOOK: When you talk about tax reform would you include additional revenues in the mix or would you want the reform to be revenue neutral?

KH: Given how much debt has increased and given the massive deficits we currently face, taking revenue off the table seems like a difficult position to defend.

Here at AEI where we looked at all of the “fiscal consolidations” that have happened in recent history -- by which I mean situations where countries faced an unsustainable deficit like ours and passed a big policy change that tried to fix it. Then we looked at whether the policy worked and the deficit went down. The typical successful consolidation was 85 percent spending cuts and 15 percent tax increases. So that’s the trade I’d be wiling to accept, 85 to 15. And the tax increase doesn’t necessarily have to be something that involves a marginal rate increase.

OUTLOOK: Yet higher taxes on the wealthy seem to be popular. For example, people tell pollsters they like the Buffett Rule (which would impose a minimum rate of 30 percent on all income above $1 million).

KH: The Buffett rule is very unlikely to ever become law because it’s just a backdoor way to increase taxes on capital gains. I think it’s a politically motivated discussion by President Obama and his team, who think it’s a conversation that will win votes. But historically members of both parties, including former President Bill Clinton, have understood the economic benefits of low taxes on capital and capital gains. If you have high taxes on capital gains you get a lock-in effect where people don’t take their capital gains out and invest in anything. It congeals economic growth and that’s been the bipartisan consensus going back decades. I think it would have a very difficult time even getting widespread support in the Democratic Party.

As for other schemes to tax the rich, Obama has of course called for the repeal of the Bush tax cuts for the wealthiest since the last campaign. But he had an opportunity to act on that. He had a supermajority in the Senate that would have allowed him in the first two years to extend all of the Bush tax cuts except the top ones and he chose not to do it. I think one of the reasons he chose not to do that during the recession is he was anxious that if they increased the top tax rate it might harm the economy. My guess is that that concern is gong to be equally valid this year.


OUTLOOK: What are the risks of a recession in the U.S. this year?

KH: I think the odds of recession in the second half of the year are roughly 50-50. If you remember what those University of Chicago professors found about uncertainty lopping 1.5 percent off growth last year and that we’re heading into a similar situation the second half of this year, then we could easily wind up in negative territory when you consider how many more issues are on the table this time.

OUTLOOK: You once wrote that coming out of a financial crisis takes more time than a normal recession. Is that the cause of the slow growth or are the president’s policies to blame, as Republicans contend?

KH: It’s a bit of both. Fiscal policies have been very ill advised. But it’s not just President Obama. It goes back to President Bush himself who was also very Keynesian and pro-stimulus at the end. The recipe one needs to follow to produce a sustained recovery was just taken off the table by both presidents’ economic teams, and we’re paying the price right now.

Let’s say you implement a Keynesian policy and have the government spend $100 billion extra this year. And let’s say you’re an optimist and believe you’ll get $200 billion in GDP out of it because the multiplier is two, so GDP goes up this year because you spent a lot of money. But next year when you take that $100 billion away then GDP will go down by the same amount, right? GDP growth will drop $200 billion next year just like it gained $200 billion this year. And the problem is that Keynesian policy doesn’t just have these two steps, it has three. It has the stimulus, the equal and opposite contraction and a third period when you pay for it with higher taxes or higher ongoing borrowing costs -- and that’s a negative as well. So if you look at the Keynesian stimulus as a whole - and this is totally apparent in the Congressional Budget Office analysis -- over a decade the stimulus is a negative.

What we need to do is put in fixes in long-term policy that will put us on a higher growth path going forward without inducing a hangover.

OUTLOOK: Why are financial crises different from other kinds of recessions?

Financial crises tend to create circumstances where financial institutions end up sitting on huge piles of bad assets. As they recapitalize, they tend to ratchet lending down significantly, putting a damper on growth for an extended period of time. Governments also inevitably take on large debts as they bail out financial institutions. Those debts crowd out private investment, and also reduce growth. It takes about 10 years to really clean up the mess.

OUTLOOK: The economist and New York Times columnist Paul Krugman has an entire book out saying we can spend our way back to higher growth. Is he in a minority among economists or is the profession pretty evenly split?

KH: I think there is very little academic support for what Krugman says or for what even the Obama team says. If you look at the academic literature you will find that stimulus is hard to time and not very successful.

OUTLOOK: If austerity is the way to go, why hasn’t it worked better in Europe?

KH: If austerity measures are designed correctly, they can set the stage for long-term growth without creating a near-term slow down. Nations that have had big fiscal consolidations are not growing slower than everybody else and more or less look much the same as everyone else. Those big fiscal consolidations have two effects. On the one hand, if government spending goes down that’s contractionary because government spending is part of GDP. But on the other hand there is a positive expectational effect because if you have a government that looks like it is less feckless then we become more optimistic about the future and start to invest.

And so the fact that nations with big fiscal consolidations look like everyone else is really positive because it means that the positive expectational effects that will lead to higher long-term growth are big enough to counteract even the short-term Keynesian effect. And so you can buy long-term growth if you put your house in order without being worried that you’ll go into recession. That’s the exact opposite of what Krugman’s been saying.

OUTLOOK: What role does government regulation have in creating uncertainty? Can it inhibit growth?

KH: Regulation can be very important but of course it’s very difficult to measure and so there’s much less convincing literature on exactly which regulations are causing the most harm. But we’ve got the Dodd-Frank financial regulations coming in with a lot of rule-making uncertainty still in play. We’ve got the EPA getting ready to regulate greenhouse gases a little more aggressively. It’s already imposed some pretty strict rulings on coal-fired power plants. And so you can definitely cite anecdotes where regulations are a problem and contribute to uncertainty. But we’ll never be at the point where we can say that regulations have reduced economic growth by, say, 1.7 percent this year. That’s the sort of precise knowledge we’ll never have.

OUTLOOK: Talk about the column you co-authored in The New York Times describing what you see as a crisis of long-term unemployment.

KH: Historically the U.S. hasn’t had a problem with long-term unemployment because we’d had such a vibrant labor market with millions of jobs being created and destroyed every month. So there’s this massive churn historically in the U.S. labor market. But right now the churn has stopped. We’re seeing net job creation every month - that is, job creation minus job destruction - of 80,000 to 100,000, while gross job creation -- meaning new jobs that didn’t exist last month - is below where it was during the trough of the recession. Firms are creating fewer jobs right now than they did even when times were as bad as you can remember.

In fact, the only reason we’re creating net jobs at all is because nobody is quitting their job - quits are at an all-time low -- because they’re so anxious that they won’t get hired somewhere else. So people get stuck out of the workforce for a long time.

What we wrote about in The New York Times is what the new research says happens to people when they’ve been out of work for a year, or two years and what sort of damage that does to themselves and their families. The statistics are chilling. I think we’re in the midst of a national emergency because we’ve got 5, 6, 7 million people who normally would have been back into the workforce by now but are at risk of being sucked into a downward spiral of separation from society. People identify with their occupation in the sense that their own sense of worth tends to come from it. So when you take away their occupation it can cause a real crisis.

OUTLOOK: What should we do about it?

KH: We need to reform job training. One program that I found particularly attractive is a German training program where very generous funds are given to firms that successfully place people who’ve been long-term unemployed. But the firms only get the funds if they successfully counsel them and transit them into employment. And it turns out that this kind of market based solution in Germany is the most successful weapon against long-term unemployment that I’ve seen in the literature. And what I’m working on right this instant is a revision in its design so it would work in the U.S. 

Third Party Link Disclaimer

You are now leaving CoBank.com. This link is provided solely as a convenience to you. If you use this link, you will leave this site and our Privacy Policy is no longer in effect. CoBank is not responsible for, and assumes no liability associated with, the practices employed by third party Web site owners.