CBO Joins the Cliff Estimating Game

Estimates of the fiscal cliff that is set to occur at the end of the year have been popping up in recent weeks. Now CBO has lended its voice to the discussion in a brief, making a number of interesting observations and quantifications with regards to the cliff.

The brief first notes that under current law, deficits are set to decline by $560 billion from FY 2012 to FY 2013 ($1.17 trillion to $610 billion). That total is the sum of $607 billion of gross deficit reduction netted against $47 billion of budgetary effects from the negative economic impact of the cliff. This deficit reduction includes $500 billion of policy changes: the expiration of the 2001/2003 tax cuts, the patching of the Alternative Minimum Tax (AMT), the implementation of the sequester, the expiration of the payroll tax cut and extended unemployment benefits, the implementation of taxes in the Affordable Care Act, and the 30 percent scheduled reduction in Medicare physician payments. Another $100 billion of deficit reduction comes from general fiscal improvement. 

Sources of Change in Deficits from FY 2012 to FY 2013 (billions)
FY 2012 Deficit -$1,171
2001/2003 Tax Cuts and AMT Patch $221
Payroll Tax Cut $95
Tax Extenders $65
ACA Taxes $18
Sequester $65
Unemployment Benefits $26
Physician Payments ("Doc Fix") $11
Non-Policy Related Changes $105
Economic Feedback Effects -$47
FY 2013 Deficit -$612

Source: CBO

Notably, CBO's previous economic outlook in January did not account for the payroll tax cut, unemployment benefits, and doc fix, which had only been extended through February rather than through the end of the year. Accounting for this change boosts their estimate of 2012 growth by 0.6 percentage points (to around 2.7 percent), but reduces 2013 growth by a similar amount to 0.5 percent. This includes a 1.3 percent contraction in the 4th quarter of 2012 and the 1st quarter of 2013, which leads CBO to conclude that this period would likely qualify as a recession. In addition, the anticipatory effects of the cliff could hurt growth by somewhere in the neighborhood of 0.5 percentage points in the second half of 2012.

They also evaluated alternative scenarios for 2013. Under a scenario of literally zero fiscal restraint--in other words, the deficit as a percent of GDP in 2013 is the same as in 2012--FY 2013 growth would be somewhere between 1.4 percent and 7.3 percent, with a central estimate of 4.4 percent. In addition, the policy would boost employment by between 600,000 and 3.4 million people, with a central estimate of two million. Obviously, this policy would be helpful strictly in the short term but would require a run-up in deficits even beyond averting the entire fiscal cliff; in other words, it would require offsetting automatic stabilizers that would automatically reduce the deficit as the economy continues to grow.

Under CBO's Alternative Fiscal Scenario, the fiscal cliff is averted with the exception of the payroll tax cut, unemployment benefits, and ACA taxes, but there is still some fiscal restraint as the deficit falls from 7.7 percent of GDP in 2012 to 6.3 percent in 2013. Growth in 2013 is somewhere between 0.8 percent and 3.4 percent, with a central estimate of 2.1 percent, while employment is between 400,000 and 2.3 million greater, with a central estimate of 1.3 million.

Economic Effects in FY 2013 of Different Fiscal Scenarios
  Real GDP Growth Change in Employment (millions)
Current Law 0.5% N/A
Zero Fiscal Restraint 1.4% to 7.3% 0.6 to 3.4
Alternative Fiscal Scenario 0.8% to 3.4% 0.4 to 2.3

Source: CBO

Although the alternate scenarios help with growth in the short term, CBO notes that these scenarios would be bad for the economy in the longer term. The AFS would run up debt to 93 percent of GDP in 2022, 30 percentage points higher than under current law. This level of debt with the economy at full capacity would crowd out private investment, would overwhelm the positive effects of extending the policies, and would limit the ability of policymakers to respond to emergencies or recessions--that is, of course, not even mentioning the increased risk of a fiscal crisis. It is less clear what the "zero fiscal restraint" scenario would do in the longer term, since it would depend on what policy prescription was followed beyond 2013.

What's the right path? Take it away, CBO:

In particular, if policymakers wanted to minimize the short-run costs of narrowing the deficit very quickly while also minimizing the longer-run costs of allowing large deficits to persist, they could enact a combination of policies: changes in taxes and spending that would widen the deficit in 2013 relative to what would occur under current law but that would reduce deficits later in the decade relative to what would occur if current policies were extended for a prolonged period...

That approach to fiscal policy would work best if the future policy changes were sufficiently specific and widely supported so that households, businesses, state and local governments, and participants in the financial markets believed that the future fiscal restraint would truly take effect. If such policy changes were enacted soon, they would tend to boost output and employment in the next few years by holding down interest rates and by reducing uncertainty and enhancing business and consumer confidence. Moreover, enacting policy changes soon would allow for implementing them gradually while still limiting further increases in federal debt and the corresponding negative consequences. Therefore, although there are trade-offs in choosing when policy changes to reduce future deficits should take effect, there are important benefits and few apparent costs from deciding quickly what those changes will be.