Consequences of Fiscal Restraint

Sarah Vanderbilt | May 30, 11:18 am

Under current law, a wide range of temporary tax and spending provisions are set to expire at the end of 2012, cutting the yearly budget deficit almost in half and as a result imposing considerable fiscal policy restraint on the U.S. economy. A recent report by the Congressional Budget Office suggests that the short-term economic consequences of letting that happen might be severe.

The Bush-era tax cuts, last extended in 2010, are set to expire at the end of the year, increasing individual tax rates and ending favorable tax treatment for investment income. The employee share of the Social Security payroll tax, last extended at 4.2 percent in February, will revert to 6.2 percent. Adjustments to the alternative minimum tax will expire, requiring an estimated 31 million additional taxpayers to pay the tax, and some revenue provisions enacted in the 2010 health care law will begin to take effect.

On the spending side, Medicare payment rates for physicians will drop and benefits for long-term unemployed workers will expire. Taken together with the automatic spending cuts set to take effect in January 2013, these budgetary changes are projected to reduce the deficit by $560 billion between fiscal years 2012 and 2013.

The projected economic effects of the scheduled fiscal policy changes, as compared with two alternatives, are shown in the graphic above. Faced with higher taxes and reduced government benefits, households are expected to cut back on spending, which would cause businesses to lower production, employment and investment.  CBO projects a 1.3 percent contraction of the economy in the first half of 2013, which it says would probably be judged a recession.

The report also notes that relaxing the fiscal policy constraints scheduled for 2013 without imposing comparable restraints in future years would result in an even worse economic outcome over the long term. Extending current policies indefinitely would create an unsustainable level of government debt that would hinder the economy by reducing national saving, increasing interest payments on the debt and increasing the likelihood of a sudden fiscal crisis.

Members of Congress are already positioning themselves on their preferred policy prescriptions for avoiding the looming, end-of-year “fiscal cliff” without abandoning long-term efforts to reduce the deficit, but serious legislative negotiations are not expected until after the November elections.


Read more at Congress Taking No Action to Address "Fiscal Cliff"

About the Data

The CBO report on economic consequences of fiscal restraint can be found here. The figures used in the graphic represent central estimate of each forecast; the full range can be found in table 2 of the report.

In addition to the policies mentioned in the graphic’s key, the current-law projection assumes that physician payment rates for Medicare will revert to much lower statutory levels, while the other two scenarios assume that the rate will be held constant.