As Congress returns to its lame duck session, it is facing one of its self-inflicted problems. WhenCongress was unable to do its job in 2011 and pass a necessary revision to the debt limit without any strings attached, it instead opted to schedule a mandatory reduction in spending to occur at the same time as a large number of tax cuts where also scheduled to expire -- January 1, 2013. Doc Jess has her take on how the President (and Congress) should handle this crisis here.
The reason that the fiscal cliff poses a major threat has to do with basic economic math which is why, contrary to the dataless theory of the Austrian School, most econmists accept that Keynesian Economics (while not necessarily the correct solution in all circumstances) has a core of truth. Grossly oversimplified, Gross Domestic Product (GDP) is the sum of Government spending (on goods and services), private Investment (in capital goods -- equipment, factories, homes), Consumer spending (on goods and services), and Exports minus Imports. Taxes, both positive (income taxes, excie taxes) and negative (payments to individuals like Social Security), have an impact by reducing the net income available for Consumer spending and private Investment. Running a deficit reduces the savings available for private Investment, thereby increasing the interest rate, while running a surplus (and paying off the debt) increases the savings available for private Investment, therey reducing the interest rate. Changes to taxes (altering the rates and altering the amount of "transfer" payments to individuals) alter the net income available for Consumer spending and private Investment.
Using that basic math, Keynesian economics posits the basic theory that the government can use its budget policies to have an impact on GDP. When other parts of the economy are slacking -- particularly Consumer spending and private Investment -- the government can fill up the slack by reducing net taxes (either by cutting tax rates or increasing transfer payments) or by increasing spending (building more roads, buying more military equipment). Since private Investment is down, the Government can run a deficit because there are excess savings available. When the economy is going full steam and threatening to overheat and develop bubbles, the government can take some of the presure off by raising taxes and cutting spending.
Implicit in this basic math is that, for the most part, a change in government fiscal policy only directly impacts GDP att he time that it takes effect and shortly thereafter as the multiplier effect (the fact that those receiving more payments from the government go ahead and spend that money for their own putchases and those from whom those purchases are made go out and make further purchases of their own, etc.). Some forms of Government spending (like some forms of private Investment) do have a continued effect on GDP -- e.g. spending on roads make it easier to transport the goods being produced and for workers to go to factories and office, spending on research leads to new goods to be produced. But for the most part, a change to fiscal policy only grows the economy once. From this basic fact comes a nasty truth, if the policy adopted to stimulate the economy during a recession is permanent (a lower tax rate or increased levels of spending) then you will need to lower taxes even more in the next recession or increase spending even more in the next recession with the result being an ever growing defecit. If on the other hand, such changes are temporary and gradually expire, the result is a surplus giving you room to adopt stimulus during a recession without running a 1.5 trillion deficit. In part, because of this basis economic math, the Congressional Research Service has apparently conlcuded that lower tax rates do not cause the economy to grow over the long term.
By adopting the fiscal cliff, Congress scheduled multiple events -- each of which will tend to reduce GDP individually -- to occur at the same time, thereby having a very big impact on GDP. Now, whether each of the steps is a good idea individually or not, doing them all at the same time is a very, very bad idea. The simple solution is to spread out these ievents.
As a possible solution, instead of the payroll tax going up by 2% on January 1, 2013, let it go up by 1% on January 1, and then 1% on October 1. Instead of cutting spendiing by $100 billion for the remaining 8 months of Fiscaly Year 2013, cut it by $25 billion with another $50 billion scheduled for Fiscal Year 2014 (and further cuts to be made based on where the economy is for Fiscal Year 2015). Instead of having all of the Bush tax cuts expire now, have some of them expire in March 2014 with the remainder to expire in 2015. (Yes for budgetary reasons, I would have them all expire in 2015).
Each of these events will slow the rate of economic growth, but, hopefully, by spreading out the shocks, this formula will avoid tipping us back into a recession. At some point, of course, we do need to discuss long range budget issues -- what tax deductions and credit do need to be repealed, how we structure entitlement programs to reflect demographic changes, how we fix our infrastructure while we still have roads, what our spending priorities shoujld be. But any changes should be gradual, not the immediate massive austerity programs that the Tea Party wants that, not surprisingly, have caused economic downturns in several European countries that have followed his extreme idea.