November 30, 2012



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By Andy Hirsch

LEWISBURG, Pa. — Greg Krohn, associate professor of economics, explains what the "fiscal cliff" really is and what could happen if the country goes over it.

Question: What exactly is the "fiscal cliff" and how did we get here?

Answer: The "fiscal cliff" refers to the substantial federal tax increases and spending cuts scheduled to take effect in January 2013. This is an unusual situation in the United States. It results from two legislative decisions. First, the tax cuts passed in 2001 and 2003 were originally scheduled to expire in 2010 in order to gain more support for them in light of the growth in budget deficits projected over the coming decades resulting from the aging of the population and rising health care costs. The expiration date was extended to the end of 2012 to avoid raising taxes when unemployment was so high and the economy slowly recovering from the 2007-09 recession. Second, the Budget Control Act of 2011 established automatic reductions in defense and non-defense spending if by the end of the year lawmakers have not enacted legislation to reduce projected deficits by $1.2 trillion through the year 2021. This was part of the deal that raised the debt ceiling in 2011 and avoided even more drastic reductions in spending.

Q: What seem to be the main sticking points for each party; what issues could get in the way of a deal before the first of the year?

A: A major part of the disagreement is about how much deficit reduction is accomplished by raising taxes and how much by cutting spending. President Obama has proposed raising income taxes on families earning more than $250,000 per year. Republicans are reluctant to raise taxes, especially if it involves raising the tax rates as opposed to reducing some tax exemptions and deductions. They insist on reforming so-called entitlement programs (Social Security, Medicare, Medicaid and other health care programs), which are the main source of projected increases in federal spending, to restrain spending growth if they are to agree on increases in taxes. The President has indicated a willingness to consider reforming the entitlement programs if taxes are raised on upper-income persons.

Q: What should we expect if lawmakers fail to reach an agreement — if we "go over the cliff?"

A: The increases in federal taxes and the reductions in federal spending that would occur in 2013 total nearly $500 billion, approximately 3 percent of gross domestic product. The Congressional Budget Office estimates that such fiscal tightening would cause inflation-adjusted gross domestic product to decline next year by 0.5 percent and the unemployment rate to rise to 9.1 percent by the end of the year.

Going off the "fiscal cliff" would sharply reduce the federal budget deficit and reduce the likelihood of a fiscal crisis stemming from an accelerating federal debt. This suggests to me that another downgrade of the country's bond rating would be less likely. On the other hand, the lack of an agreement on a more prudent federal budget policy may indicate weakness in the ability to govern the nation effectively, and this might contribute to a downgrade.

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