The fiscal cliff has become a hot topic of discussion, albeit one where the heat may exceed the light. Some argue that it is not a cliff; it's a "slope." Some say that going over the fiscal cliff is nothing to fear and could easily be repaired afterward. And even some who understand the danger of the cliff argue there is time before the economy begins to feel its effects.
The reality is that the fiscal cliff is a danger; a danger that is harming economic growth now and will increasingly do so as the year progresses.
How so? Recall that the fiscal cliff is a combination of $440 billion in tax hikes and $200 billion in spending cuts scheduled to happen at the end of 2012. The tax increases stem from the sunset of the 2001 and 2003 tax laws, the middle class falling into the trap of the alternative minimum tax, the sunset of the recent payroll tax holiday, and the new taxes under the health care reform. In each case, Congress could act extend the tax laws, patch (as is customary) the AMT, and so forth to avoid the damaging tax increases.
Similarly, the spending cuts could be avoided. Over one-half are across-the-board cuts to defense and non-defense spending known as the "sequester" required by the budget deal that raised the debt ceiling in 2011. The remainder stem from ending enhanced benefits for the uninsured and a scheduled cut in the reimbursements to doctors under Medicare. And, again, Congress could undertake a combination of customary (extend UI, pay the doctors) and new actions (replace the sequester with other, longer-range cuts) to avoid the sharp impact.
To put the size of the fiscal cliff into perspective, note that the U.S. economy will produce over $15 trillion worth of goods and services in 2012, or about 2 percent (or roughly $300 billion) more than it produced last year. In other words, the size of the punch packed by the fiscal cliff is twice as large as the likely economic growth of 2012. Worse, there is abundant evidence that the response of consumers and businesses to fiscal policy amplifies its impact on the economy through a so-called "multiplier effect." The ultimate impact is hardly certain, but as outlined in a recent paper by Ike Brannon and me (http://americanactionforum.org/sites/default/files/Fiscal%20Cliff.pdf), a large recession is clearly in the offing.
The fiscal cliff is indisputably a future danger.
Perhaps more importantly, it is already beginning to affect the U.S. economy. For example, equity market investors face the prospect of the dividend tax rate tripling from 15 to nearly 45 percent. They have every incentive to get out before approaching the cliff. Is it any surprise that the stock market has wobbled so visibly in recent weeks?
Businesses face the combination punch of higher taxes and reduced federal procurement spending. Is it any surprise that indicators of manufacturing activity have weakened and orders for durable goods plummeted recently?
Workers for government contractors are waking up to the threat of layoffs, and their families are seeing big tax hikes in a few months. It is hardly a surprise that household spending continues to limp along.
In short, markets, firms, and families are smart enough to see a potential train wreck in the offing and take steps now to anticipate it. They will not wait until it hits and will not look kindly upon strategies that suggest they sit on their hands and have the situation fixed next year.
The fiscal cliff is a legacy of the failure to make real, permanent fixes to key tax and spending programs. Real reform must happen in 2013.
Between now and then, the fiscal cliff remains an anchor on economic growth and a threat for actual recession.