Policymakers are facing difficult trade-offs in formulating the nation’s fiscal policies. On the one hand, if the fiscal policies currently in place are continued in coming years, the revenues collected by the federal government will fall far short of federal spending, putting the budget on an unsustainable path. On the other hand, immediate spending cuts or tax increases would represent an added drag on the weak economic expansion.
In fact, under current law, increases in taxes and, to a lesser extent, reductions in spending will reduce the federal budget deficit dramatically between 2012 and 2013—a development that some observers have referred to as a “fiscal cliff”—and will dampen economic growth in the short term. CBO has analyzed the economic effects of reducing that fiscal restraint. It finds that reducing or eliminating the fiscal restraint would boost economic growth in 2013, but that adopting such a policy without imposing comparable restraint in future years would have substantial economic costs over the longer run.
CBO estimates that the combination of policies under current law will reduce the federal budget deficit by $607 billion, or 4.0 percent of gross domestic product (GDP), between fiscal years 2012 and 2013. The resulting weakening of the economy will lower taxable incomes and raise unemployment, generating a reduction in tax revenues and an increase in spending on such items as unemployment insurance. With that economic feedback incorporated, the deficit will drop by $560 billion between fiscal years 2012 and 2013, CBO projects.
If measured for calendar years 2012 and 2013, the amount of fiscal restraint is even larger. Most of the policy changes that reduce the deficit are scheduled to take effect at the beginning of calendar year 2013, so budget figures for fiscal year 2013—which begins in October 2012—reflect only about three-quarters of the effects of those policies on an annual basis. According to CBO’s estimates, the tax and spending policies that will be in effect under current law will reduce the federal budget deficit by 5.1 percent of GDP between calendar years 2012 and 2013 (with the resulting economic feedback included, the reduction will be smaller).
Under those fiscal conditions, which will occur under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects—with the economy projected to contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half. Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession.
CBO analyzed what would happen if lawmakers changed fiscal policy in late 2012 to remove or offset all of the policies that are scheduled to reduce the federal budget deficit by 5.1 percent of GDP between calendar years 2012 and 2013. In that case, CBO estimates, the growth of real GDP in calendar year 2013 would lie in a broad range around 4.4 percent, well above the 0.5 percent projected for 2013 under current law.
However, eliminating or reducing the fiscal restraint scheduled to occur next year without imposing comparable restraint in future years would reduce output and income in the longer run relative to what would occur if the scheduled fiscal restraint remained in place. If all current policies were extended for a prolonged period, federal debt held by the public—currently about 70 percent of GDP, its highest mark since 1950—would continue to rise much faster than GDP.
Such a path for federal debt could not be sustained indefinitely, and policy changes would be required at some point. The more that debt increased before policies were changed, the greater would be the negative consequences—for the nation’s future output and income, for the burden imposed by interest payments on the federal debt, for policymakers’ ability to use tax and spending policies to respond to unexpected challenges, and for the likelihood of a sudden fiscal crisis. And the longer the necessary adjustments in policies were delayed, the more uncertain individuals and businesses would be about future government policies, and the more drastic the ultimate changes in policy would need to be.
They could address the short-term economic challenge by eliminating or reducing the fiscal restraint scheduled to occur next year without imposing comparable restraint in future years—but that would have substantial economic costs over the longer run. Alternatively, they could move rapidly to address the longer-run budgetary problem by allowing the full measure of fiscal restraint now embodied in current law to take effect next year—but that would have substantial economic costs in the short run. Or, if policymakers wanted to minimize the short-run costs of narrowing the deficit very quickly while also minimizing the longer-run costs of allowing large deficits to persist, they could enact a combination of policies: changes in taxes and spending that would widen the deficit in 2013 relative to what would occur under current law but that would reduce deficits later in the decade relative to what would occur if current policies were extended for a prolonged period.