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Just How High Is the Fiscal Cliff?

Rob Silverblatt

For the rest of the year and likely beyond, President Obama and Congress will tangle at the edge of the fiscal cliff, that mix of expiring tax breaks and government spending cuts that will take effect during 2013 and beyond, and could determine whether the economy sinks back into recession.

If they can't reach any sort of deal, a newly austere government sector would quickly put downward pressure on GDP growth and would drive unemployment up to 9.1 percent by the end of next year, according to a report released Thursday by the Congressional Budget Office (CBO).

"Output would be greater and unemployment lower in the next few years if some or all of the fiscal tightening scheduled under current law--sometimes called the fiscal cliff--was removed," the CBO concluded.

But there are a slew of other scenarios outlined by the CBO. In its report, entitled "Economic Effects of Policies Contributing to Fiscal Tightening in 2013," the CBO measured the impact of various alternatives to the fiscal cliff. For all its calculations, it assumed that planned cuts would be delayed by two years and then take effect. Here's a look at how some of those changes--defense cuts, and nondefense and Medicare payment cuts--could impact the economy.

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In one model, the CBO estimated that if the automatic cuts to defense spending, which are scheduled to kick in as part of the Budget Control Act unless Congress reaches an agreement in the next two months, are avoided, the effect would be to "increase real GDP by 0.4 percent and increase full-time-equivalent employment by about 0.4 million in the fourth quarter of 2013." The CBO suggested that sidestepping the reductions would "boost GDP in 2013 by about $1.20 for every dollar of budgetary cost in that year; the full range of estimates runs from $0.50 to $2.00 of GDP per dollar of budgetary cost."

The CBO also looked at the impact of avoiding cuts to nondefense spending and cancelling out planned lower payments to doctors under Medicare. The enforcement procedures of the Budget Control Act will, according to the CBO's tally, slash nondefense outlays by $30 billion next year. If those cuts, as well as other changes to the way Medicare compensates physicians, are forestalled, GDP would further increase next year, although the effects per dollar spent could be less significant than they would be in the case of a delay to defense cuts.

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"Those economic effects per dollar are smaller than the effects of the changes in defense spending because a larger share of the affected nondefense spending represents government payments to people or state and local governments, rather than direct purchases of goods and services," the CBO explained. "Because people and state and local governments would not spend all of such payments in 2013, the increases in nondefense spending have a smaller per-dollar effect on aggregate demand."

The CBO is quick to warn, however, that mere Band-Aid measures aimed to temporarily forestall the cliff would be harmful in the long term. "Although reducing the fiscal tightening scheduled to occur next year would boost output and employment in the short run, doing so without imposing a comparable amount of additional tightening in future years would reduce the nation's output and income in the longer run relative to what would occur if the scheduled tightening remained in place," the report noted.

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By comparison, if the economy falls over the cliff (so to speak) next year, the situation could begin to stabilize as early as 2014. "After next year, by the agency's estimates, economic growth will pick up, and the labor market will strengthen, returning output to its potential level (reflecting a high rate of use of labor and capital) and shrinking the unemployment rate to 5.5 percent by 2018," the report noted.

Regardless of whether the cliff materializes, the uncertainty surrounding the situation has already taken its toll. "Many firms appear to be uncertain today about future demand for their products, and that uncertainty seems to be leading them to be cautious about increasing their investment and hiring," the CBO observed. "Fiscal policy actions that boosted demand might lessen that uncertainty and increase employment."

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