Dragged to the Fiscal Slope

Implications of “I am not a member of an organized political party. I am a Republican.” (with apologies to Will Rogers)

The collapse of Speaker Boehner’s Plan B has been interpreted as signaling that the Speaker never had the votes from his caucus for any deal with the President. [1] If this interpretation is correct, then we should prepare for something like the following trajectory of GDP:


Figure 1: Log GDP (blue), log forecast GDP under current law, from August 2012 (red), and GDP if all Bush tax cuts extended plus AMT fix (green square). NBER defined recession dates shaded dark gray; implied informal recession dates shaded light gray. Source: BEA, 2012Q3 3rd release; 2012Q4 assumes 1% growth SAAR (from MacroAdvisers (12/20/2012); CBO, Budget and Economic Outlook: An Update (August 2012), CBO, Economic Effects of Policies Contributing to Fiscal Tightening in 2013 (November 2012), NBER, and author’s calculations.

I included a 2013Q4 projection of GDP assuming tax increases for income less than $250K are eventually eliminated (green square). In light of this evening’s events, I think this seems a bit optimistic –- it is not clear that the right wing of the Republican Party would allow a partial tax cut; all or nothing seems to be the current stance. In any case, this estimate is based upon the August 2012 CBO projection. To the extent that one believes the current-law trajectory of GDP is lower, the implied level of 2013Q4 GDP is commensurately lower.

As CBPP’s Chad Stone has pointed out, the CBO projection assumes immediate implementation of the provisions. Some could be delayed until some agreement could be made, thereby possibly avoiding a downturn (e.g., the green square in my optimistic scenario). One can only hope.

Update, 11:25am Pacific: Noam Scheiber/TNR says we go over the cliff temporarily, and then:

Well, at that point, the world starts to look pretty good for the Democrats and the White House. First, as Jonathan Chait and Ezra Klein have pointed out, because all the Bush tax cuts will have expired, the $1.2 trillion in tax increases Obama is seeking suddenly become a $3.8 trillion tax cut. (The expiration of the Bush tax cuts would produce about $5 trillion in revenue over 10 years; $5 trillion minus the $1.2 trillion Obama in revenue wants will leave $3.8 trillion for taxpayers to pocket.)

Better yet, polls overwhelmingly show that the public will blame Republicans for pushing us over the cliff. As things stand today, House Republicans can tell themselves voters are on their side. Many won re-election with upward of 60 percent of the vote. In their minds, Obama has no more of a mandate than they do. It’s only the arbitrary coincidence of the Bush tax cuts expiring and the automatic spending cuts kicking in next year that gives him leverage. If we go over the cliff, on the other hand, that self-delusion will get harder to maintain by the hour. The public backlash will be intense. The media coverage will amplify it to the nth degree. Conservative pundits will turn on them, as will Senate Republicans (whose leader, Mitch McConnell, was conspicuously silent after Boehner’s Plan B went down in flames). The House will be completely isolated and will see that it’s not Obama who’s trying to pull one over on them, it’s voters who are demanding that they act. It will play out in much the same way as their surrender on the payroll tax cut last year, with House Republicans completely intransigent until they were abruptly squashed by public opinion and abandoned by their own party. So the middle class tax cuts will be extended and the upper income cuts will mostly expire.

20 thoughts on “Dragged to the Fiscal Slope

  1. jonathan

    I believe I noted in other comments that individual GOP House members have no reason to vote for a tax increase because their primary challenges will come from the right. The deal discussed would not only have them vote for tax increases but for raising the debt ceiling, so they’d be labeled tax and spenders. So the incentives for the GOP members are to wait and then vote to lower taxes.
    I think something else is happening. That is 1/1 is a material event and that means we essentially have a two round game: negotiations before the event and after. This means much of what is going on is signaling expected future strength after the event or bluffing about that. Given the process so far, I think the parties are unclear about what their strengths actually will be in the 2nd game round.

  2. 2slugbaits

    I’m actually a little more optimistic after last night’s collapse of “Plan 9 from Outer Space.” The next Congress will have fewer Republicans, different committee assignments and fewer very hard right Tea Party clowns; e.g., Joe Walsh and Allen West. Even one of Boehner’s top lieutenants referred to them as “chuckleheads.” What’s driving this immediate craziness is Boehner’s concern for his speakership. This is actually something that Nancy Pelosi can help him with because becoming Speaker requires a majority of the full House, not just the majority of the majority. So the Democrats are in a position to promise him his continued speakership in exchange for relaxing a bit on a strict interpretation of the “Hastert rule” requirement.
    jonathan their primary challenges will come from the right
    I’m not so sure that this will be as true as it once was. Even Grover Norquist was willing to give Republicans a pass on Plan 9. Norquist went through all kinds of tortured intellectual gymnastics to try and pretend that voting for Plan 9 would not be breaking the pledge. And we’ve seen how the groups that funded many of those far right challengers are rethinking their positions. Karl Rove has made it clear that he will fight challenges from the far right if that challenge threatens an otherwise winnable seat. And FreedomWorks is a mess right now. So I think that a lot of these threats from the kooky right have more or less played themselves out.

  3. Bruce Carman

    Corporate profits after tax as a share of GDP recently reached a post-WW II record high at just short of 11%. Profits are highly cyclical. The average for profits/GDP during recessionary and bear market troughs is 4.5-5%.
    The risk is that the next recession and bear market will coincide with a decline in profits of 50-55%, matching or exceeding the decline in ’08-’09, implying a decline in profits of nearly $1 trillion (equivalent to 9 million jobs).
    This corresponds to a decline in reported earnings for the S&P 500 to the long-term trend line going back to the 1930s, 1970s, and ’02 and the implied recessionary trough for earnings in the $40s vs. $87 today.
    Note that the 50-55% cyclical decline in reported earnings and corresponding stock price decline would not be historically anomalous but typical.
    Reported earnings are about to turn negative yoy as occurred at the onset of the last two recessions and bear markets in ’08 and ’01.
    The cyclical rhythm for profits, stock prices, and the coincident pattern for real GDP per capita, investment, employment, incomes, and gov’t receipts is already entrained as a consequence of the Long Wave debt-deflationary depression regime and secular bear market for stocks.
    The secular debt-deflationary forces will progressively overwhelm policies that tweak taxes, deficits, and spending at the margin, rendering the fiscal cliff issue a political distraction.
    The fiscal cliff is an effect of the Long Wave slow-motion depression since ’01, not a cause of an incipient cyclical recession and bear market.

  4. Steven Kopits

    I think the Dems have accepted the fiscal cliff. And I think you’re edging to it to, Menzie. (So more stimulus is not necessary, eh? All that need to move to potential GDP and higher employment–not so important anymore?)
    For the Dems, it’s all or not enough. They will not have a better chance to raise taxes all around. So pretty much January is your shot for the next four years, and I think we’re all beginning to realize that.
    Americans voted for Big Government, and now they’re going to get a chance to pay for it.
    The rest is just about trying to blame it on the Republicans.

  5. Menzie Chinn

    Steven Kopits: Do I sound like I’m happy that we are moving to the fiscal slope? I don’t think anybody else reading the post sees me interpreting that outcome as a happy one.

  6. Bruce Carman

    “Want Big Government, gotta pay for it.”
    Steven, the bottom 90% of US households have been paying for BIG (local, state, and federal) GOV’T (massive war spending, higher payroll taxes on workers and employers, runaway college tuition costs, etc.), deindustrialization (loss of goods-production employment from offshoring), financialization ($42 trillion in debt added to the economy since ’82), and peak US crude oil production (60% decline per capita since ’70) for 30-42 years.
    Now we can no longer afford to increase public and private debt to increase real GDP per capita.

  7. 2slugbaits

    Steven Kopits You seem very confused about the fiscal cliff. How did you come to the conclusion that Democrats secretly relish going over the cliff because Democrats are for big government??? Do you not realize that going over the fiscal cliff doesn’t just mean an increase in tax rates, it also means savage cuts in social spending? It’s bad enough that the economy will suffer a contractionary effect due to a sudden increase in tax rates, but the cuts in government spending will have an even stronger contractionary effect.
    Let’s review what those of us on the left side of the aisle would like to see. The immediate task should be to repeal the Bush tax cuts for those making over $250K. That won’t fully close the deficit gap, but it will make a big dent (approx $160B/yr) and it will do so without shocking aggregate demand. After the economy gets its sea legs we will need to raise taxes again, this time including the middle class. I would suggest a small income tax increase alongside a VAT of (say) 2%. A lot of the countercyclical spending will go away by itself once the economy recovers. Defense spending should be cut.
    Now what about entitlements? Social Security doesn’t have anything to do with our debt problem because it is funded separately. So GOP calls to cut Social Security spending amount to trying to solve a non-problem. Now over the very long-run it is true that Social Security’s solvency is an issue; but that is a relatively easy problem to fix and should be handled on its own. Medicare & Medicaid are the big elephants in the room. They are a huge entitlement problems; but they are no bigger than healthcare in general. Do you really trust today’s Republicans to fix healthcare?

  8. Joseph

    The president of the American Enterprise Institute makes his contribution to conservative scholarship regarding the fiscal slope yesterday in the Wall Street Journal. He cites a study showing that people who go on welfare have a 16% higher likelihood of feeling sad and makes the impressive leap from effect to cause, concluding that welfare causes sadness. Therefore we can increase happiness by kicking people off welfare.
    I’m always fascinated by these glimpses into the fetid recesses of the conservative brain. It’s like witnessing the aftermath of car wreck you know is going to be horrible but you can’t look away.

  9. Ep3

    So if we let the bush tax cuts expire, then we get $5 trillion over ten years in tax revenue? But the politicians would rather fight over $1.2 trillion?
    I can’t afford for my taxes to go up in January. But I can’t afford to eat cat food when I am in my 60s. So I would rather take the hit now than when I am older and can’t work anymore.

  10. Darren

    So if we let the bush tax cuts expire, then we get $5 trillion over ten years in tax revenue? But the politicians would rather fight over $1.2 trillion?
    This is an assumption made by some, that will come up embarrassingly short.
    1) In the 90s, the demographics of the US were more inclined towards GDP growth, as baby-boomers were in their peak earning years, rather than nearing retirement, as they are now.
    2) In the 90s, govt. spending was low enough to have a balanced budget and even a brief surplus.
    3) Obamacare adds a new 3.8% tax to high income people, that did not exist in the 90s.
    4) California has a much higher state income tax than in the 90s. This means California residents will have a *much* higher tax rate than in the 90s.
    5) Emerging markets like China and India were very much smaller in the 90s, so the US had far, far less competition. Now, capital has more places to fly to, than in the 90s.
    6) We no longer get the same caliber of skilled immigrants as in the 90s, since their home countries are now better places than they were then.
    So, the notion that letting the Bush tax cuts expire will increase revenue, is going to embarrass a lot of people. The US will finally be forced to compete on tax friendliness, which it did not have to pay heed to before.
    Of course, tax simplification would be an even bigger boost to the economy than anything else.

  11. Darren

    BTW, one tax increase I *do* support is to remove the deduction for State/Local income taxes in the Federal tax code.
    High-tax states like CA, NY, MA, NY, and IL are getting a free ride at the expense of TX, FL, WA, NV, etc. This deduction enables badly-managed blue states to conceal their failure at the expense of low-tax states.
    Remove that deduction. First and foremost.
    Secondly, remove the mortgage-interest deduction. A dumb idea for sure, that also subsidizes coastal CA, NYC, and Boston at the expense of the rest of America where most houses cost under $300K. Canada has no mortgage deduction, and gets by just fine.
    Thirdly, remove the deduction for employer healthcare.
    Fourthly, remove the deduction for charitable contributions (many non-profits are just political arms of the socialist state).
    Yep. Remove all those deductions.

  12. benamery21

    Silver’s point about the numbers is spot on. Not sure why Silver decided to use self-identification of Congresscritters as his grouping mechanism, however, the fact is that if you look at the work of Poole (which he references) it is easily seen that we have the most partisan House ever. The partisan tilt is primarily a result of the Republican representation having moved from center-right to far-right (about 3/5ths of Rebublicans are so far right that Tea Party is an appropriate grouping). That said, the narrowest ideological spectrum required for a majority in today’s house would cover all of the center and themainstream of both parties, including about 3/5ths of Democrats and 2/5ths of Republicans. Unfortunately, the breadth of that spectrum is huge, and there is a big gap in the center (which gap is why it doesn’t run closer to either edge).

  13. Anonymous

    I Want to be a Consumer
    “And what do you mean to be?”
    The kind old Bishop said
    As he took the boy on his ample knee
    And patted his curly head.
    “We should all of us choose a calling
    To help Society’s plan;
    Then what to you mean to be, my boy,
    When you grow to be a man?”
    “I want to be a Consumer,”
    The bright-haired lad replied
    As he gazed into the Bishop’s face
    In innocence open-eyed.
    “I’ve never had aims of a selfish sort,
    For that, as I know, is wrong.
    I want to be a Consumer, Sir,
    And help the world along.”
    “I want to be a Consumer
    And work both night and day,
    For that is the thing that’s needed most,
    I’ve heard Economists say,
    I won’t just be a Producer,
    Like Bobby and James and John;
    I want to be a Consumer, Sir,
    And help the nation on.”
    “But what do you want to be?”
    The Bishop said again,
    “For we all of us have to work,” said he,
    “As must, I think, be plain.
    Are you thinking of studying medicine
    Or taking a Bar exam?”
    “Why, no!” the bright-haired lad replied
    As he helped himself to jam.
    “I want to be a Consumer
    And live in a useful way;
    For that is the thing that is needed most,
    I’ve heard Economists say.
    There are too many people working
    And too many things are made.
    I want to be a Consumer, Sir,
    And help to further trade.”
    “I want to be a Consumer
    And do my duty well;
    For that is the thing that is needed most,
    I’ve heard Economists tell.
    I’ve made up my mind,” the lad was heard,
    As he lit a cigar, to say;
    “I want to be a Consumer, Sir,
    And I want to begin today.”
    Patrick Barrington (1932)

  14. JBH

    “$5 trillion minus the $1.2 trillion Obama in revenue wants will leave $3.8 trillion for taxpayers to pocket.” Precisely a misuse of the English language, and precisely what the fiscal cliff is all about. According to the US Constitution, these $3.8 trillion monies belong to those who earned them. If the decades long trail of legislation that took those monies away was legal, so was the Bush tax cut in giving them back. Now that law reverts the government’s hand back into the taxpayers’ pocket, a small majority in the House is attempting to stop this sedulous action.

    The fiscal cliff is a bit player. The greater role by far goes to what Bruce Carmen describes: “Now we can no longer afford to increase public and private debt to increase real GDP per capita.” Coupled with this at center stage is the slide of this great nation over the far graver cliff the Leviathan of big government is taking it. There is a triple reason for cutting spending to allow the productive members of society to keep their just desert – a desert being wrenched away from them by the unproductive class now able to swing elections. Taxation hurts growth; cutting spending will pare back the Leviathan that is taking America to its knees; and in this light spending cuts are the preferred means to engineer the turndown of public debt that is so necessary and pressing. Reinhart Rogoff’s work predicts economic growth will be at a snail’s pace in coming decades otherwise. The grim outlook is growth will grind its way to zero per capita.

    Sally Ride gives a link to Krugman wherein: “So a rising-monopoly-power story would be one way to resolve the seeming paradox of rapidly rising profits and low real interest rates.” There is no paradox. The Kalecki (purely NIPA accounting) equation dictates that the corporate profit share rise in direct proportion to government and consumer dissaving. The other part of the “paradox”, historic low rates, is a direct result of the Federal Reserve – part of the Leviathan – taking the bond and credit markets wholly out of the hands of the free market. We come full circle to Bruce Carmen’s point about public and private sector debt, the antithesis of a nation’s all-vital surplus. And at the same time lay bare the underlying motivation of crony capitalism, the incestuous lying down together of corporate CEOs and politicians who augur ever for bigger government.

    The public hasn’t the foggiest clue … otherwise on the margin enough voters would be swayed and this would not be allowed to go on.

  15. tj

    Hope you all had a Merry Christmas! I have had no access to media for a couple of weeks. Has Obama’s “balanced” proposal been put forth? I am referring to the “balanced” approach he ran on.
    I think the right has stated their approach of deduction caps and cuts to spending growth. Some middle ground should emerge once we see Obama’s dollar for dollar spending cuts to match his tax rate increases.
    Let me guess…whatever happens will occur at the last minute and be crammed through Congress before the public is aware of the details.
    I think the folks, including myself, who benefited from the build up of public debt need to step up and accept less than they expected from social security, medicare and public pensions. If the federal government would have been more repsonsible in the first place, then benefits and/or after-tax income would have been lower anyway. Why make the next generation pay for it? Shouldn’t the cost be paid by those who benefited from lower tax rates and higher public debt?

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