Avoiding the ‘fiscal cliff’: short-term benefits, but long-term pain

Last week’s US ‘fiscal cliff’ deal might help avoid some short-term budget strain, but in the longer run, it will do little to stem the growth of US debt

By David Lawder  /  Reuters, WASHINGTON

Tue, Jan 08, 2013 - Page 9

So does the US Congress’ landmark deal to avert the “fiscal cliff” by canceling tax hikes on most US citizens increase or decrease long-term US budget deficits?

The answer is a definitive “yes,” the US Congressional Budget Office (CBO) said on Friday.

It all depends on the comparison. And by the way, it also helps — and hurts — the economy.

As it said earlier last week in its official budget scoring of the legislation passed on Jan. 1, the deal adds US$4 trillion to deficits over a 10-year period compared to allowing all income tax rates to jump back to their pre-2001 levels and allowing automatic spending cuts to bite — effectively a leap off the fiscal cliff.

Add in the increased debt service costs through 2022, and you have US$4.6 trillion in new debt burden. The main culprit is simple: The legislative deal brings in less revenue than called for by tax laws that would have reinstated the old rates.

However, few in Washington believed it was realistic to allow a full return to the tax rates of former US president Bill Clinton’s era, sharply lower Medicare payments to doctors and a failure to stop the dreaded alternative minimum tax from ensnaring ever-larger numbers of middle-class taxpayers.

So the CBO last year came up with an alternative scenario, which assumed that all tax rates were left unchanged and the Alternative Minimum Tax (AMT) indexed for inflation. Had this been enacted, deficits would have risen US$4.5 trillion, or US$5.2 trillion including debt service costs, the CBO estimated in August last year.

After making some adjustments in the agency’s calculations due to the fiscal cliff legislation, CBO Director Doug Elmendorf said in a blog posting that the deal would produce 10-year budget savings of US$600 billion to US$700 billion compared to this alternative tax-extension scenario.

Add in lower debt service costs, and the savings would be US$700 billion to US$800 billion.

The CBO also had predicted that going over the fiscal cliff had dire consequences for the economy, plunging it back into recession. This would have caused US GDP to shrink by 0.5 percent this year — a huge plunge from US Federal Reserve forecasts of 2.3 percent to 3 percent growth.

An economy in recession generates less tax revenue and prompts higher spending on unemployment benefits, which widens a deficit and forces more borrowing.

However due to last week’s deal, the CBO’s estimate is now back in the black, with the office expecting GDP growth of around 2.5 percent to 2.75 percent this year. However, this could decline due to some further fiscal tightening still on the books for this year.

The CBO’s analysis does not include any further spending cuts that the US Congress may make in the next two months as a looming battle over the federal debt limit heats up.

However, longer term, CBO estimates that the fiscal cliff deal will reduce GDP output compared to allowing all of the tax rates to snap back to Clinton-era levels.

While some short-term pain will be avoided, it will do little to halt the growth of US debt in the long run. The debt service costs and the lower national savings and reduced capital stock associated with this will eventually start to sap economic growth, the CBO said.

By contrast, the CBO had previously predicted that the greater amount of deficit reduction achieved by going over the fiscal cliff would start to pay dividends in higher growth by the end of the decade.