Policymakers face difficult trade-offs in deciding how quickly to implement policies to reduce budget deficits. On the one hand, cutting spending or increasing taxes slowly would lead to a greater accumulation of government debt; on the other hand, immediate spending cuts or tax increases would represent an added drag on the weak economic expansion. Under current law, the federal budget deficit will fall dramatically between 2012 and 2013 owing to scheduled increases in taxes and, to a lesser extent, scheduled reductions in spending—a development that some observers have referred to as a “fiscal cliff.”
Today CBO released an analysis of the economic effects of that fiscal restraint. Under those fiscal conditions, growth in real (inflation-adjusted) gross domestic product (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.
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, the growth of real GDP in calendar year 2013 would lie in a broad range around 4.4 percent, CBO estimates, 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 would rise much faster than GDP, a path that could not be sustained indefinitely.
Benjamin Page of CBO’s Macroeconomic Analysis Division prepared the analysis under the supervision of Wendy Edelberg and Kim Kowalewski.