The Horrific Accident Awaiting Us Over The Fiscal Cliff

Published in Forbes

With the U.S. elections rapidly approaching, only to be quickly followed by the “Bush tax cuts” expiring at the end of the year in the absence of action by the President and a soon-to-be lame duck Congress, the reality is that failure to confront this deadline will result in a wave of tax spikes that will cause heavy job losses, reduce economic activity significantly, and produce a hit to financial markets that could set the economy off into another recessionary tailspin.  Our focus is on the tax piece of the “Fiscal Cliff.”

Stark political lines have been drawn.  Republicans have called for a quick, temporary across-the-board extension for all tax cuts until real tax reform can be undertaken.  President Obama and Democratic leaders are amenable to temporary extensions but are standing firm against extending any tax cuts for the wealthy.

The stakes are extremely high in this game of political poker, so it is important to know the ramifications of the bets, particularly when it comes to the potential substantial costs of inaction.  Decision Economics, Inc. (DE) undertook an economic study to examine the potential effects of various scenarios where the legislated tax-rate increases on income, dividends, capital gains and social security take place.  If policymakers cannot come to an agreement and the country wakes up on January 1, 2013 to large tax increases, the impacts would be dramatic and sobering; indeed, perhaps even before as financial markets anticipate the deadly possibility.
Job Losses:  Large declines in persons working, over 1 million estimated in 2013 and in excess of 3.5 million in 2014.  The unemployment rate would rise 0.4 percentage points in 2013 and an extremely large 1.5 percentage points in each of 2014 and 2015.

This would move the unemployment rate toward 9%, reversing its intended direction of movement and worsening the already negative economic, political and societal consequences of a continuing depressed jobs market.

Declines in Economic Growth:  Significant declines in real economic growth of 2.6, 3.3, and 0.5 percentage points over 2013 to 2015—up to $855 billion of lost output, which would take the economy into negative territory and another recession.

Lower Consumption Spending:  Lower consumption spending, down about $1 trillion per year, on average, over 2013-17, beginning with a relatively small decline of $343 billion in 2013 and jumping to $1.2 trillion in 2015.

Reduced Capital Spending:  Substantial hits to business capital spending with losses of $13.4 billion in 2013, $68.5 billion in 2014, and $95.2 billion in 2015.

Financial Market Disarray:  Reduced employment, reduced consumer spending and reduced capital spending with major negative effects on corporate earnings.  The stock market very likely would sell off sharply, estimated at nearly 18% per year over 2013 to 2017.  This represents real money being lost in the retirement and pension accounts of ordinary Americans.

Deficits and Debt:  Even worse, the intended aim of the tax increases to reduce deficits and debt relative-to-GDP would be overwhelmed by the losses of real GDP and much lower prices, after the first year, ex-post, with higher deficits and higher debt-to-GDP ratios, not lower.  This austerity program of tax increases, like the now-discredited austerity used in the Eurozone, would prove totally counterproductive just as it has there.  Rather than improve the federal budget position, it would worsen, with the same negative interaction of fiscal restraint on economic activity than GDP with fewer tax receipts than originally expected, along with problems for financial institutions and a need to consolidate balance sheets in a collapsing world.
If policymakers allow lower tax rates on capital gains and dividends to expire, the economic consequences will be substantial.

A return to the 20% capital gains tax rate and taxing dividends at ordinary income tax rates (a maximum of 39.6% from the current 15%) would cause a reduction in real GDP by 1.3 percent and over 1 million fewer jobs in 2015 compared to the baseline forecast.  Savings would weaken considerably and, of course, higher taxes on capital gains and dividends would have large negative impacts on the stock market, which, in turn, will raise the cost of capital for business.

It is important to understand the role of capital gains and dividend taxes and their significance in the U.S. economy. Higher taxes on capital gains and dividends, abstracting from issues of equity and fairness, reduce real economic growth, cause weaker consumption and decreases in business capital spending, reduce employment, and labor force growth, and help bring about less potential output.

Driving over the Fiscal Cliff is an unthinkable option.  Across-the-board extensions of the tax cuts, even if only for a year or two, are the best way to sustain the U.S. economic upturn and to avoid a European-style crisis.  Policymakers concerned about the political ramifications of this monumental debate would be wise to heed the words of income and capital gains tax-cutting former President John F. Kennedy, who noted, “There are risks and costs to a program of action, but they are far less than the long-range risks and costs of comfortable inaction.”

Allen Sinai is Chief Global Economist and President, Decision Economics, Inc. (DE); New York, London, Boston, Chicago.  Margo Thorning is Senior Vice President and Chief Economist for the American Council for Capital Formation (ACCF), a nonprofit, nonpartisan organization advocating tax, energy, regulatory and environment policies that facilitate saving and investment, economic growth and job creation.

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