No doubt we are in for some unexpected twists and turns after the election tomorrow. But despite the uncertainty about the outcome of the election and the exact actions the winner will take, much of the immediate future of fiscal policy is predictable. That's because no matter who gets the most electoral votes, that president will have to face -- and now I want to use a technical term -- the "post-election fiscal mess."
The post-election fiscal mess has three parts.
First, there is the so-called fiscal cliff -- the $600 billion of unwanted deficit reduction that the Congressional Budget Office estimates could cost the economy 2 million jobs.
The fiscal cliff can be subdivided into five parts: (1) the expiration of the Bush tax cuts on December 31; (2) the expiration of the 2 percentage point payroll tax cut on December 31, 2012; (3) the sequestration spending cuts -- half on defense, half spread through the rest of the federal government -- scheduled to take effect on January 1, 2013; (4) the absence of alternative minimum tax relief for tax year 2012; and (5) other relatively small stuff.
As many commentators have pointed out, the use of the word "cliff" is misleading. Fiscal slope is more like it. There may be a legal date certain as to the onset of most of these items, but the economic effects are gradual. Already the uncertainty in anticipation of possible tax increases and spending cuts is putting a freeze on investment spending and hiring. And that will only get worse as the new year approaches. The effects on taxpayer cash flows and government spending after January 1, 2013, may be delayed for a short while. The full impact of the fiscal cliff -- that estimated loss of 2 million jobs -- will be felt only in the unlikely event that all the tax cuts are in effect for the full year and there is no retroactive relief.
Getting much less attention, but much more scary, is the approaching debt limit. If you will recall, it was the debt limit that triggered the failed budget negotiations in the summer of 2011 and ultimately led to the debt downgrade of the United States by Standard & Poor's on August 5, 2011. Moody's has all but promised to also downgrade if we see anything like the repeat of those events.
What makes the debt limit so frightening is the tremendous uncertainty about the economic consequences of breaching it. The effects of the fiscal cliff may be big and bad, but at least they are well understood. There is no economic model to predict the effects of the issuer of the world's safest asset being unable to pay its bills. Moreover, the term "cliff" is much more appropriate here. Once confidence is lost in Treasury securities, we may be unable to put that genie back in the bottle.
The third part of the post-election fiscal mess is the main event: long-term deficit reduction. Unlike the fiscal cliff and the debt limit, the problem of long-term deficit reduction is not coming to a head because of some artificially contrived deadline. It is the product of forces largely outside the government's control, such as globalization -- which pressures the United States to develop a more competitive tax system -- and demographic changes that put greater demands on revenue than ever before.
Getting a deal on long-term deficit reduction is commonly referred to as a grand bargain. The figure you most often hear tossed around is $4 trillion over 10 years. More specifically, that is $4 trillion less of deficits than would occur in the CBO current-policy baseline, which includes extension of all the Bush tax cuts. As you can see from Figure 1, this is more than enough to put the government on a fiscal path that is sustainable. "Sustainability" is a bare-bones standard for deficit reduction meaning the debt-to-GDP ratio will be stabilized. This translates into an annual deficit of about 3 percent of GDP.
Getting government finances on a sustainable path will not be easy. Although the current-policy baseline will yield revenue more or less in line with historical averages, mandatory spending is estimated to increase by 2.5 percent of GDP just over the next decade (see figures 2 and 3). And unless you are counting on an unexpected economic surge, as occurred during the dot.com boom in the late 1990s, the notion of balancing the budget at any time is pie-in-the-sky wishful thinking.
Figure 1. $3.4 Trillion of Deficit
Reduction for Sustainability
Source: CBO, "An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022," Aug. 2012, Doc 2012-17803
Only after we get through all three parts of the post-election fiscal mess can we start talking in earnest about tax reform. There has been a tremendous upsurge in interest in tax reform in the last few years. Some of it has been sparked by concerns about lack of competitiveness, but for the most part it has not been tax reform for its own sake but as a sweetener to help get a deal on deficit reduction.
Figure 2. Federal Revenue as a Percentage of GDP, 1972-2023
Figure 3. Effect of Aging and Rising
Healthcare Costs on Deficit