December 11, 2012

The Fiscal Cliff: The Worst of Both Worlds

Charles Blahous

J. Fish and Lillian F. Smith Chair
Summary

Without legislative action, millions of Americans’ tax bills will suddenly rise and federal spending will be suddenly cut. Many economists believe that allowing all this to happen simultaneously will have severe adverse economic effects, possibly plunging the nation back into recession.

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Without legislative action, millions of Americans’ tax bills will suddenly rise and federal spending will be suddenly cut. Many economists believe that allowing all this to happen simultaneously will have severe adverse economic effects, possibly plunging the nation back into recession.

We are in this situation primarily because elected officials have become addicted to inserting “sunset” provisions into laws they don’t actually intend to terminate. This is a classic game-theory conundrum in which the players all face incentives to do the wrong thing, despite knowing that the end result is bad for everyone.

Political pressure and congressional “pay-go” rules, which require revenue increases or cuts elsewhere in the budget to offset new spending or tax reductions, serve as impediments to laws that transparently add to the deficit. So instead of admitting that many policies we favor do add to the deficit, we pretend that they will only be with us briefly and that their budget effects can be painlessly counteracted with minor offsets.

The result is the worst of all policy worlds. Any positive economic effects of tax relief and government spending are undercut, as both taxpayers and beneficiaries lack certainty about whether, when, and how existing policies will be extended. Meanwhile we have a false picture of our fiscal situation, which forces government scorekeepers to keep two sets of books: one for what current law says and another representing their predictions of what Congress will actually do (namely, keep adding temporary extensions to allegedly sunsetting laws).

The president, whoever he is, would do the nation an enormous service if he began his term by leading a successful bipartisan effort to end this proliferation of temporary policies. Any further short-term extensions of these laws should be coupled with realistic permanent schedules to replace them. The worst possible scenario, which some analysts have advocated, would involve doing the opposite on both counts: suffer the economic damage from going over the fiscal cliff, only to follow that up with yet another round of temporary “mitigating” policies.

Although it will be extremely difficult for the parties to reach long-term agreements, it is in their mutual interest to do so, since both major parties’ preferred policies are persistently undermined by current practices. Long-term schedules for income tax rates and Medicare physician payments eventually will emerge one way or another; it is better for this to happen according to a coherent long-range plan than through a series of stopgap measures. There will never be a better time to negotiate such an agreement than at the start of a new presidential administration.

While many existing policies should simply be made permanent, there is one that should be immediately terminated: the Social Security payroll tax cut of 2011−12, a prototypical example of shortsighted policy. Elected officials hoped this cut might give the economy a quick shot in the arm, but they did not want to cut the benefits that the tax finances. So they incorporated a provision to subsidize Social Security from the general fund, carelessly ending decades of bipartisan commitment to the principle that Social Security benefits should be fully earned and that the program should pay its own way. The year following a presidential election is the time to leave such temporary gimmicks behind and to adopt a new economic approach based on long-term stability and consistency.