Barron's Cover
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SATURDAY, NOVEMBER 10, 2012
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Shock Treatment
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By GENE EPSTEIN
The so-called fiscal cliff has all to do with tax increases and almost nothing to do with spending cuts. Can the economy survive?
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Scott Pollack for Barron's
When Ben Bernanke gets concerned, the rest of us should start worrying. "If the fiscal cliff isn't addressed," warned the Federal Reserve chairman in a Sept. 13 appearance before the Senate Finance Committee, "I don't think our tools are strong enough to offset the effects." After thus disavowing central-bank responsibility if the U.S. economy falls of the fiscal cliff, Bernanke plaintively added, "So I think it's really important for the fiscal policy makers to, you know, work together and find a solution."
Nearly two months later -- and just days after the presidential election -- policy makers have yet to find a solution, mainly for lack of trying. On Friday, Republican House Speaker John Boehner and newly re-elected President Barack Obama declared their intention to try to work together to avert the fiscal cliff. If they fail, the Congressional Budget Office has warned of a "contraction in output in the first half of 2013 [that] would probably be judged to be a recession." From real growth in gross domestic product in the second half of this year that is likely running at an annual rate of 2%, the CBO projects a contraction in the first half at an annual rate of 1%.
The fiscal cliff is far less about spending cuts than it is about tax increases. As commonly defined, the fiscal cliff refers to an unusual combination of federal tax hikes coinciding with reductions in federal spending, all of them coming on Jan. 1, 2013. Indeed, a Wall Street Journal front-page story last week spoke, for example, of "deep, automatic federal-spending cuts and tax increases."
Wrong. While the tax increases will certainly be steep, the "deep" spending cuts are much shallower. More important, the spending cuts will be more than offset by inexorable increases in the cost of entitlement programs.
The net result will be no reduction in federal spending. The cuts popularly cited mainly consist of automatic reductions under the 2011 Budget Control Act that require equal dollar cuts in defense and nondefense programs starting in fiscal 2013, through an action known as sequestration.
Painful as those cuts may be, however, they are not enough to cause the government's overall spending to decline. Projections by the nonpartisan Congressional Budget Office and the White House's Office of Management and Budget both show that overall dollar spending won't decrease in calendar year 2013. What all the projections do show is a much slower rate of increase.
That's partly because the huge influx of aging baby boomers will be laying just claim to their Social Security benefits right on schedule. So we are again dealing with the budgetary newspeak of decreases in spending that are really just a reduction in the increase.
Even that smaller-than-usual increase might be somewhat understated. Both CBO and OMB might have erred on the side of optimism about one wild card in federal spending, the cost of servicing the burgeoning federal debt. Since the federal budget will still be running a deficit, the outstanding debt will grow.
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But OMB and CBO both project only a modest increase in servicing cost based on the assumption that interest costs will stay at their historical lows. If not, total federal spending will increase by even more.
Those sensitive to the nuances of fiscal policy might still argue that even a slowdown in the rate of increase in spending still has dampening effects on the economy. But that sin of omission should still have much less of an impact than the far larger sin of commission on the tax side.
The CBO projects nearly a half-trillion-dollar jump in tax revenue in calendar 2013 that has no offsets. According to CBO estimates, that will mean a 2.7% increase in tax as a share of GDP. To put that figure in perspective, there has not been a single year since 1970 when an increase in federal tax revenue ran even as high as 1%, with just three years of +0.9%. The last year comparable to this was one was 1969, when the rise in tax revenue as a share of nominal GDP ran 2.1%. By fourth quarter 1969, the economy had slipped into recession.
FOR STARTERS, IT'S CLEAR THAT, if spending and investing power proportionate to 2.7% of GDP is drained from consumers and business over the course of a year through higher taxes, there is likely to be a slowdown in economic activity. Whether the result will be outright recession depends on something more difficult to gauge -- the extent to which the tax hikes really do shock, taking consumers and business by surprise. When consumers and business are relatively unprepared, the slowdown in economic activity is likely to be greater.
Nearly two months later -- and just days after the presidential election -- policy makers have yet to find a solution, mainly for lack of trying. On Friday, Republican House Speaker John Boehner and newly re-elected President Barack Obama declared their intention to try to work together to avert the fiscal cliff. If they fail, the Congressional Budget Office has warned of a "contraction in output in the first half of 2013 [that] would probably be judged to be a recession." From real growth in gross domestic product in the second half of this year that is likely running at an annual rate of 2%, the CBO projects a contraction in the first half at an annual rate of 1%.
The fiscal cliff is far less about spending cuts than it is about tax increases. As commonly defined, the fiscal cliff refers to an unusual combination of federal tax hikes coinciding with reductions in federal spending, all of them coming on Jan. 1, 2013. Indeed, a Wall Street Journal front-page story last week spoke, for example, of "deep, automatic federal-spending cuts and tax increases."
Wrong. While the tax increases will certainly be steep, the "deep" spending cuts are much shallower. More important, the spending cuts will be more than offset by inexorable increases in the cost of entitlement programs.
The net result will be no reduction in federal spending. The cuts popularly cited mainly consist of automatic reductions under the 2011 Budget Control Act that require equal dollar cuts in defense and nondefense programs starting in fiscal 2013, through an action known as sequestration.
Painful as those cuts may be, however, they are not enough to cause the government's overall spending to decline. Projections by the nonpartisan Congressional Budget Office and the White House's Office of Management and Budget both show that overall dollar spending won't decrease in calendar year 2013. What all the projections do show is a much slower rate of increase.
That's partly because the huge influx of aging baby boomers will be laying just claim to their Social Security benefits right on schedule. So we are again dealing with the budgetary newspeak of decreases in spending that are really just a reduction in the increase.
Even that smaller-than-usual increase might be somewhat understated. Both CBO and OMB might have erred on the side of optimism about one wild card in federal spending, the cost of servicing the burgeoning federal debt. Since the federal budget will still be running a deficit, the outstanding debt will grow.
.
But OMB and CBO both project only a modest increase in servicing cost based on the assumption that interest costs will stay at their historical lows. If not, total federal spending will increase by even more.
Those sensitive to the nuances of fiscal policy might still argue that even a slowdown in the rate of increase in spending still has dampening effects on the economy. But that sin of omission should still have much less of an impact than the far larger sin of commission on the tax side.
The CBO projects nearly a half-trillion-dollar jump in tax revenue in calendar 2013 that has no offsets. According to CBO estimates, that will mean a 2.7% increase in tax as a share of GDP. To put that figure in perspective, there has not been a single year since 1970 when an increase in federal tax revenue ran even as high as 1%, with just three years of +0.9%. The last year comparable to this was one was 1969, when the rise in tax revenue as a share of nominal GDP ran 2.1%. By fourth quarter 1969, the economy had slipped into recession.
FOR STARTERS, IT'S CLEAR THAT, if spending and investing power proportionate to 2.7% of GDP is drained from consumers and business over the course of a year through higher taxes, there is likely to be a slowdown in economic activity. Whether the result will be outright recession depends on something more difficult to gauge -- the extent to which the tax hikes really do shock, taking consumers and business by surprise. When consumers and business are relatively unprepared, the slowdown in economic activity is likely to be greater.
.
.
As for any shock and surprise on the spending side, half the spending cuts mandated by the 2011 Budget Control Act will fall on defense, and were probably anticipated. It's unclear how much shock will be caused by the tax increases.
The looming fiscal cliff has gotten so much play in the media that it already has probably placed a damper on economic activity. And to the degree that it has, one saving grace is that consumers and business will be better prepared for the cliff's effects.
As Stanford University economist John Taylor recently pointed out on his blog, "The fiscal cliff was not created by aliens from outer space. It is another poor government policy created in Washington." When we look on the tax side (see above), we see an odd assortment of inadvertent reversals of tax cuts all converging at the same time.
In his address Friday, President Obama made it clear that he wants to retain the tax cuts on the first $200,000 of taxable income for individuals and $250,000 for couples. It turns out that most of the pending increases in terms of sheer dollars will fall on these "non-rich." So the president should have a natural desire to strike a deal.
The largest impact ($161 billion) consists of the still-pending rollback of the tax cuts passed under former President George W. Bush. According to Obama's own Office of Management and Budget, nearly 60%, or $95 billion, of what would be raised by rolling back the tax cuts would come from taxpayers who fall below the income thresholds of $250,000 for couples and $200,000 for single people. Both sides of the aisle will probably favor postponement for this group, especially because $95 billion will do a lot to blunt the tax shock.
The president made it clear Friday that he plans to restore these taxes on the richest 2%, which will raise the remaining $66 billion. A substantial portion of that ($28 billion) is expected to fall on their dividends and capital gains. Boehner, however, made it equally clear that he's against "raising taxes on the wealthiest Americans."
Regarding the $66 billion that OMB estimates could be realized though higher taxes on the top 2%, the estimated $28 billion from dividends and capital gains could be too high. Steeper tax rates can alter behavior, especially investment behavior. The full realization of that $28 billion depends on the size of the dividends received and capital gains realized.
Investors now face a neutral trade-off between dividends and long-term capital gains, since both are taxed at 15%. With the rollback of the tax cuts, the level playing field will be tilted once again, with capital gains taxed at 20% and dividends taxed as ordinary income, with rates as high as 39.6%. That sort of differential will mean a return of the perverse desire by investors to have companies reinvest earnings rather than distribute them as dividends, in the hope that the reinvested earnings will turn into more lightly taxed capital gains. The result will be what economists have referred to as a "lock-in" effect, with harm to economic efficiency.
Another tax that falls mainly on the non-rich is the alternative minimum tax ($114 billion). Each year, a taxpayer is supposed to pay the AMT or a regular tax, whichever is greater. But since the AMT was hurting middle-income taxpayers, an exemption roughly indexed to inflation, called a "patch," has been protecting them against its effects. The last exemption expired in December 2011, however, which means income earned in 2012 could feel the influence of the AMT. Since the bad news will be learned by taxpayers when they file their returns, the CBO projects that the huge sums will be paid almost entirely in 2013.
It seems likely, however, that the patch on the AMT will have a good chance of getting extended. Less likely -- so far, at least -- will be the continuance of the cut in the payroll tax on employees by two percentage points (worth $120 billion), instituted in January 2011. That payroll-tax holiday, which is technically hurting the solvency of Social Security, doesn't seem popular with the White House.
BUT IF POLICY MAKERS do take Fed Chairman Bernanke's warning seriously, everything should be on the table. That would mean rescinding many of the tax hikes, while less happily reversing the spending cuts, thus allowing federal spending to increase faster than planned. No matter which way it gets done, the result would be a widening of the fiscal deficit.
That might set off alarms. For those deficit hawks concerned about red ink virtually without end, why not sit back and celebrate the fiscal contraction otherwise known as the fiscal cliff?
The standard drug-addict analogy helps answer that question. Much as we might have opposed shooting up the economic patient with such huge doses of fiscal-deficit heroin to begin with -- much as we might welcome the ultimate return to balanced-budget sobriety -- we might still fear the consequences of withdrawal if the dose gets cut so drastically in so short a time.
The economy's deficit habit must be abandoned, or the build-up in debt will cause a major crash. But the fiscal cliff, or tax shock, poses a great risk to economic growth in 2013. Our leaders must therefore kick the deficit-reduction can down the road yet one more time. We might take comfort in knowing that they have a talent for that sort of activity.
.
.
As for any shock and surprise on the spending side, half the spending cuts mandated by the 2011 Budget Control Act will fall on defense, and were probably anticipated. It's unclear how much shock will be caused by the tax increases.
The looming fiscal cliff has gotten so much play in the media that it already has probably placed a damper on economic activity. And to the degree that it has, one saving grace is that consumers and business will be better prepared for the cliff's effects.
As Stanford University economist John Taylor recently pointed out on his blog, "The fiscal cliff was not created by aliens from outer space. It is another poor government policy created in Washington." When we look on the tax side (see above), we see an odd assortment of inadvertent reversals of tax cuts all converging at the same time.
In his address Friday, President Obama made it clear that he wants to retain the tax cuts on the first $200,000 of taxable income for individuals and $250,000 for couples. It turns out that most of the pending increases in terms of sheer dollars will fall on these "non-rich." So the president should have a natural desire to strike a deal.
The largest impact ($161 billion) consists of the still-pending rollback of the tax cuts passed under former President George W. Bush. According to Obama's own Office of Management and Budget, nearly 60%, or $95 billion, of what would be raised by rolling back the tax cuts would come from taxpayers who fall below the income thresholds of $250,000 for couples and $200,000 for single people. Both sides of the aisle will probably favor postponement for this group, especially because $95 billion will do a lot to blunt the tax shock.
The president made it clear Friday that he plans to restore these taxes on the richest 2%, which will raise the remaining $66 billion. A substantial portion of that ($28 billion) is expected to fall on their dividends and capital gains. Boehner, however, made it equally clear that he's against "raising taxes on the wealthiest Americans."
Regarding the $66 billion that OMB estimates could be realized though higher taxes on the top 2%, the estimated $28 billion from dividends and capital gains could be too high. Steeper tax rates can alter behavior, especially investment behavior. The full realization of that $28 billion depends on the size of the dividends received and capital gains realized.
Investors now face a neutral trade-off between dividends and long-term capital gains, since both are taxed at 15%. With the rollback of the tax cuts, the level playing field will be tilted once again, with capital gains taxed at 20% and dividends taxed as ordinary income, with rates as high as 39.6%. That sort of differential will mean a return of the perverse desire by investors to have companies reinvest earnings rather than distribute them as dividends, in the hope that the reinvested earnings will turn into more lightly taxed capital gains. The result will be what economists have referred to as a "lock-in" effect, with harm to economic efficiency.
Another tax that falls mainly on the non-rich is the alternative minimum tax ($114 billion). Each year, a taxpayer is supposed to pay the AMT or a regular tax, whichever is greater. But since the AMT was hurting middle-income taxpayers, an exemption roughly indexed to inflation, called a "patch," has been protecting them against its effects. The last exemption expired in December 2011, however, which means income earned in 2012 could feel the influence of the AMT. Since the bad news will be learned by taxpayers when they file their returns, the CBO projects that the huge sums will be paid almost entirely in 2013.
It seems likely, however, that the patch on the AMT will have a good chance of getting extended. Less likely -- so far, at least -- will be the continuance of the cut in the payroll tax on employees by two percentage points (worth $120 billion), instituted in January 2011. That payroll-tax holiday, which is technically hurting the solvency of Social Security, doesn't seem popular with the White House.
BUT IF POLICY MAKERS do take Fed Chairman Bernanke's warning seriously, everything should be on the table. That would mean rescinding many of the tax hikes, while less happily reversing the spending cuts, thus allowing federal spending to increase faster than planned. No matter which way it gets done, the result would be a widening of the fiscal deficit.
That might set off alarms. For those deficit hawks concerned about red ink virtually without end, why not sit back and celebrate the fiscal contraction otherwise known as the fiscal cliff?
The standard drug-addict analogy helps answer that question. Much as we might have opposed shooting up the economic patient with such huge doses of fiscal-deficit heroin to begin with -- much as we might welcome the ultimate return to balanced-budget sobriety -- we might still fear the consequences of withdrawal if the dose gets cut so drastically in so short a time.
The economy's deficit habit must be abandoned, or the build-up in debt will cause a major crash. But the fiscal cliff, or tax shock, poses a great risk to economic growth in 2013. Our leaders must therefore kick the deficit-reduction can down the road yet one more time. We might take comfort in knowing that they have a talent for that sort of activity.
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