Falling off the Fiscal Cliff

Posted: Oct 30, 2012 12:01 AM
Falling off the Fiscal Cliff
It may not be intuitive to nonbusiness people and economists why increased taxes and reduced federal spending will send the US into a recession. However, it is not hard to understand the economic logic that causes this result.

If the highest income tax rate increases from its current 35% to 44% (including Medicare and Obamacare tax increases) on the wealthiest taxpayers, a high income family making $500,000 will have $45,000 less to spend. That family may decide to cut out a gardener, housekeeper, vacation, or even a new yacht. A progressive might say "so what, they are rich, and they will still have an opulent life style." Unfortunately, that does not help the newly unemployed housekeeper or gardener find a job.

If the high income family made its money from a small business, such as a restaurant, they may decide not to cut out personal spending but to reduce investment in their restaurant. Perhaps they decide not to buy the new $45,000 replacement dining tables. That hurts the table manufacturer who does not need as many workers making the tables. So, he lays off an excess employee. Perhaps the restaurant will decide to buy the replacement tables and instead lays off a waiter earning $45,000. Service will be slower, but the owner's family can pitch in to take up the slack. (Although, they may not need to if business slows down due to the multiplier effect discussed below.)

Unfortunately, the unemployed housekeeper or waiter will have to make much larger cuts to his or her budget. Not only are they eliminating the minor luxuries of life, like eating out, but they may have to eliminate essential services; e.g. sell their car, or move out of their apartment and move in with extended family. As a result, people providing these essential services have less money. They in turn make similar cuts to their staff which results in additional unemployment. Economists refer to these secondary layoffs caused by lack of spending by the employees initially laid off as the multiplier effect.

If each taxpayer making over $500,000 directly or indirectly reacted to the tax increase by laying off one employee, a million high income taxpayers would react similarly by laying off one million people! Lower income families hit by the tax increase would react similarly. With the multiplier effect, perhaps another million people would be laid off.

The impact of the $120 billion reduction in federal spending will have a similar impact. If only half the spending reduction is achieved by reducing employment of $50,000/yr employees,over a million people will be laid off. These layoffs will also have a multiplier effect leading to additional layoffs and higher unemployment.

Similar logic applies to the reduction of national income. If people are laid off, they spend less money on products and services. Businesses sell less and have lower income. The reduction in national business income and national employment will lead to a reduction of national income. (Roughly defined as Gross Domestic Product.) Reduced national income also has a multiplier effect further reducing national income and employment. The economists at the CBO estimate that this tax increase and spending cut could result in an additional 3 million Americans being unemployed. They also estimate that the country will have 2.9% less income to spend.

There is also a psychological aspect to the fiscal cliff. Many analysts believe that individuals, investors and businessmen in this country are in economic limbo because they are concerned about the "fiscal cliff". The business and financial community does not like uncertainty. They do not know whether the US will go over the fiscal cliff and enter a recession. They prepare for the worst. Consequently, they save money and do not spend money today because in a recession "Cash is King". If the fiscal cliff were to be eliminated, these individuals, businesses and investors might be more inclined to spend money. This would immediately help stimulate the economy.

The fiscal cliff is a direct result of the failed leadership of the Obama administration. The President created this problem by failing to get congress to agree on a responsible fiscal policy and trying to put off the difficult tax and spending issues by "kicking the can down the road." Obama rationalizes his responsibility for creating the fiscal cliff by saying that he wants to prevent a tax cut for the rich. He has clearly stated that he wants to raise taxes on the rich even if it does not stimulate the economy or create additional tax revenue because it is "the right thing to do!" Isn't stimulating the economy and creating jobs for unemployed Americans "the right thing to do?" A competent President would not tolerate a fiscal cliff during a tepid recovery.