How the Fiscal Cliff Deal Hurt a Recovering Economy

Posted: Jan 07, 2013 6:14 PM
The deal that Congress came to on the fiscal cliff last week was a combination of half-measures, compromise, and kicking-the-can that nobody seemed to like but was overwhelmingly approved. Most of the meaures that constituted the cliff stood poised to harm the economy over the next two years - and Congress' failure to offset the cost of averting the cliff will result in a worse economy in the long run.

As Americans everywhere found out with their first paychecks of the new year, Congress failed to reauthorize the temporary payroll tax cut that expired. This could result in between 300,000 and 1.3 million fewer jobs created over the next two years. Reauthorizing the payroll tax cut, however, would have needed budget-tightening offsets to minimize long-term damage to the economy.

While the effects of the high-income tax hikes will be somewhat mitigated due to Congress raising the income threshold, it's still going to cost the economy some jobs in the short-term.

Economist Peter Morici estimates that unemployment will remain steady next year when what obviously needs to happen is that the economy grows and unemployment shrinks. And in the long-term, Morici writes, "the likelihood of a downgrade in the U.S. credit rating by Moody's is increasing, and this will weigh on the investment plans of many U.S. multinational corporations.

While averting most of the fiscal cliff will help in the short term, it'll cost us in the long term. For example, the full extension of unemployment insurance is estimated to add 0.5% to economic growth next year, but because everything in the cliff - including the tax cuts - is deficit-financed, the U.S. will be worse off in ten years than if nothing was done.

The Congressional Budget Office's analysis of the cliff legislation last week clarifies:

Although we expect that the legislation just enacted by the Congress will lead to higher output and income in 2013 we also expect that it will lead to lower output and income later in the decade than would have occurred under prior law. The legislation lowers tax rates for many people—thereby boosting output —but it also expands budget deficits—which will reduce national saving and lower the stock of productive capital, thereby reducing output relative to what would have occurred under prior law.

The fiscal cliff deal was a massive compromise between many different and competing factions and, therefore, has no coherent vision for the economy. As Jim Tankersley of the Washington Post explains:

Economists generally offer three theories for what’s hampering the still- sluggish U.S. economy: the Keynesian theory, which would like to see lower taxes or more government spending; the spending/debt theory, which would like to see both of those reined in; and the uncertainty theory. Under none of them can the deal to avert the “fiscal cliff” be considered an economic success.

Like almost all legislation that comes out of "grand bargain" sessions in Washington, the fiscal cliff was far from the optimal outcome. Yes, it's not the worst thing that could have happened, but there's a very good case to be made that the legislation that resulted, because it likely won't be offset down the road, has made the U.S. worse off in the long run.