Wednesday, August 22, 2012

CBO and the fiscal cliff

The CBO has released a report warning that a new recession could follow the  "fiscal cliff"

Background: Here's the CBO report and a Washington Post story  A few snippets from the CBO:

What Policy Changes Are Scheduled to Take Effect in January 2013?...

  • A host of significant provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312) are set to expire, including provisions that extended reductions in tax rates and expansions of tax credits and deductions originally enacted in 2001, 2003, or 2009. ...["Bush tax cuts expire"]
  • Sharp reductions in Medicare’s payment rates for physicians’ services are scheduled to take effect.
  • Automatic enforcement procedures established by the Budget Control Act of 2011 (P.L. 112-25) to restrain discretionary and mandatory spending are set to go into effect.
  • Extensions of emergency unemployment benefits and a reduction of 2 percentage points in the payroll tax for Social Security are scheduled to expire.

What Is the Budget and Economic Outlook for 2013?

CBO’s Baseline: Taking into account the policy changes listed above and others contained in current law, under CBO’s baseline projections:
  • The deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4.0 percent of GDP), almost $500 billion less than the shortfall in 2012.
  • Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013...
And from the Post:
The nation would be plunged into a significant recession during the first half of next year if Congress fails to avert nearly $500 billion in tax hikes and spending cuts set to hit in January, congressional budget analysts said Wednesday.

The agency foresees a stronger contraction of 2.9 percent in gross domestic product, "similar in magnitude to the recession of the early 1990s." [I couldn't find thi].
“The magnitude of the slowdown we’re discussing next year is significant,” CBO director Douglas Elmendorf said at a morning briefing. He noted that going over the cliff could cost the nation about 2 million jobs.
Elmendorf said the shock of the cliff would be felt for years to come, with the unemployment rate stuck above 8 percent through 2014. And the effects are likely to be felt well before the fiscal cliff hits, according to the budget outlook released Wednesday, as “businesses’ and consumers’ concern about the scheduled fiscal tightening will lead them to spend more cautiously than they otherwise would have” during the remainder of 2012.
What do I make of this? I think the fiscal cliff is a big problem -- but that the CBO's analysis is way off.

The CBO’s projections are deeply and explicitly Keyneisan, relying on “multipliers.” If the government borrows a billion dollars and blows it on some useless porkbarrel project, the CBO will project that this raises GDP  to the tune of one and a half billion dollars. In analyzing the “fiscal cliff,” reducing such projects is bad for the economy.  That’s the key source of their estimate that the fiscal cliff leads to recession. If you, like me, think that the government spending less money on useless projects (say, ethanol subsidies) has a positive effect on output, or that taking less money from A and giving it to B has little effect, then you will not be so worried.

It used to be that the first thing you had to understand to call yourself an "economist" is that prices and taxes are first and foremost about incentives, and only secondarily about income transfers. That is especially true when thinking about national output, growth, etc. Income transfers matter a lot to people, but the overall economy really doesn't care who has the wealth. It cares about incentives.

A really good example: What will the effect on output and employment be of ending 99 weeks of unemploment insurance? That's part of the fiscal cliff, and the CBO's analysis (see above) says that reducing unemployment insurance will lower GDP. Really? A standard economic analysis comes to exactly the opposite conclusion. Generous unemployment and disability means that some people choose to stay unemployed rather than take lower-paying jobs, or jobs that require them to move.  So long as you stay unemployed, you get a check from the government. Subsidizing anything produces more of it. So, a standard analysis says that cutting back unemployment insurance lowers unemployment, and raises output and this part of the fiscal cliff analysis should go the other way.

Before you go all nuts on how heartless I am, keep the question in mind. I didn't say what's good or bad, I said what raises or lowers GDP and unemployment. The standard analysis of unemployment insurance says, yes, it raises unemployment and lowers GDP, but it provides important insurance for the truly needy and unfortunate. It's something we do out of compassion even though it hurts us.

But the CBO didn't score national welfare, or a compassion index. They scored GDP and unemployment, and their model comes to the opposite conclusion, subsidizing unemployment causes more GDP and less unemployment. As well as being compassionate. How do we have our cake and eat it too? Well, that's the magic of Keynesian economics, on which I will not digress here.  

So, in my view, most of the analysis is simply wrong. 

That doesn't mean I think the fiscal cliff is has no effect.

As a "standard" economist, I look first and foremost at incentives. Raising marginal tax rates lowers incentives to work, save, invest, start businesses.  That's not good. So I agree that the tax part of the fiscal cliff will drag down the economy. But not because it reduces Keynesian stimulus, but because it worsens incentives.

The bigger problem with the fiscal cliff is the utter chaos of it all. What serious country decides its tax laws year by year, in one big chaotic crisis during the first few weeks of the year? Will estate taxes be 55% or 0% next year? Who knows?

Moreover, this last-minute crisis atmosphere is ripe for salting the tax code with little goodies which nobody will notice until it's too late. It's a fiesta for lobbyists, tax lawyers and crony-capitalists of all stripes.

This is not how any serious country operates, let alone the supposed leader of the free world. And annual tax chaos is certainly not good for GDP.

What will the effects of the fiscal cliff be? I can't tell.  The incentive and expectations effects that I think matter aren't in any of the Washington models.

Moving from "scoring the law" to "forecast," we also have to think if the cuts will actually happen.  The CBO also has to make forecasts based on Congress’ promises. But do you really believe congress’ promises? Not even the CBO does, really, which is why they make “alternative” forecasts.
Congress hasn't passed a budget in years. Will the supposedly mandatory cuts really happen? Congress can spend money on anything it wants to. It's not like someone will sue them for violating the sequester, any more than someone can sue them for blatantly violating the budget act.

A great example is the  "reductions in Medicare’s payment rates for physicians’ services" mentioned in the CBO report. I presume their model scores this as having a reduced stimulus effect since doctors will buy fewer BMWs.  I doubt its actual effect of doctors simply refusing to work are in the CBO model.

But in any case, it won't happen. Congress promises every year that next year it will cut health costs by simply paying doctors less. They then change their minds at the last minute, because, duh, doctors won’t work without getting paid. It seems a sure bet to me that will happen again, with "emergency" reauthorization. Ditto for important priorities like farm subsidies, the export import bank, ethanol subsidies, electric car subsidies and so on. 

So, my guesstimate of the fiscal cliff? Mild drag on GDP from chaos and higher marginal tax rates. Very little effect on spending, which will be restored in a sequence of last minute bills. Therefore, very little reduction in deficit. Continuation of our slide into low-growth sclerosis.
Update: As a commenter noticed, I'm being too kind. Jacking the estate tax back to 55% alone should be a great stimulus measure to get old folks to spend money on round the world cruises, private jets and tax lawyers.

I was working on this some more and ran in to the CBO's supporting documentation here  of which tax provisions are going to expire. To the CBO each of these is a little foregone Keynesian stimulus. To me the list is reminder A of what an obscenity our tax code has become. Yes, let's drop them all, yesterday!
Cellulosic Biofuel Credit,Credit for Past Minimum Tax Liability,Depreciation of Certain Ethanol Plant Property,Election to Accelerate AMT and R&E Credits in Lieu of Electricity Production Credit for Wind Facilities, Exclusion of Mortgage Debt Forgiveness ,Indian Coal Production Credit,Partial Expensing of Investment Property,Recently Discharged Veterans Eligible for WOTC,Section 179 Expensing, Andean Trade Preference Initiative,Generalized System of Preferences,Deduction for Energy-Efficient Commercial Buildings,Depreciation Classification for Certain Race Horses,Determination of Low-Income Housing Credit Rate,Energy Credit for Nonwind Facilities,Electricity Production Credit for Nonwind Facilities,Partial Expensing of Certain Refinery Property,Liquefied Hydrogen Fuel Incentives,Credit for Motor Vehicles with Fuel Cell,Hydrogen Refueling Property,African Growth and Opportunity Act,Noncommercial Aviation Fuel Rates for Certain Aircraft,AGI Floor for Individuals 65 or Older Remains at 7.5 Percent,Credit for Business Solar Energy Property,Credit for Residential Energy-Efficient Property,Earned Import Allowance Program for Dominican Republic,Haitian Value-Added Rule for Apparel,Increase Excise Tax on Coal,Caribbean Basin Trade Partnership Act,Haiti Trade Preferences,Fuel Surtax on Certain Aircraft,Transfer of Excess Assets in Defined-Benefit Plans..............


  1. The example of physician reaction to Medicare cuts is incorrect. They don't work less. Several resposes occur across this heterogeneous group:

    1. Stop accepting Medicare.

    2. Reduce the number of Medicare patients.

    3. Game the system. Ironically, this is most easily accomplished using EMR, which the government is forcing them to adopt.

    4. Increase volume of patients seen by spending less time per patient.

    5. Don't change anything and just make less money until you go bust.

    6. Dilute the quality of service using physician extenders like physician assistants or nurse practitioners.

    7. Retire due to increasing regulatory burden, the hassle of fighting wth insurance companies, and decreasing fees.

  2. One thing you don't mention: the fiscal cliff may be one of the reasons why measures of economic policy uncertainty (cf. Bloom et al.) are elevated at the moment.

    This in itself may be retarding GDP/job growth now.

  3. The fiscal cliff isn't going to happen no matter what. It could take well into January to correct, and this is technically after the economy jumps off the cliff, it will get correct by January 31.

  4. Even by Keynesian metrics unemployment benefits have no impact on output. These are transfer payments, which even a Keynesian using Y = C + I + G + X has to admit is not included in G.

  5. I agree that there will be a drag in GDP due to "chaos and higher marginal tax rates", but I wouldn't categorize it as "mild". That is because it is more than just "marginal tax rates". There are substantial (as unprecedented in their scope) increases in capital gains taxes - up from 58.6% to 100%, if one includes Obama's 'Buffet Rule', dividend taxes - up to as much as 189% (now, that is the definition of "unprecedented"), State taxes, social Security taxes (the exemptions end), the highest corporate tax in the world (with its unique 'territorial' double taxation in place), and regulatory pressures galore.
    It seems like a master plan for those that want capital to flee in a panic, and it almost doesn't matter where.
    But perhaps the worst aspect is that GDP will be affected "permanently".

    We present the dividend case in our piece, "The Coming Tax Ambush On Seniors' Dividends" at America's Chronicle.

    1. Good comment. For once I am guilty of understating the damage.

    2. Hold on - the fiscal cliff refers to tax/spending changes already written into current law. The Buffett rule is not. It may be on the President's wish list, but it's important to remember that rises in Capital Gains/Dividend taxes are *not* automatically scheduled to increase from January 2013.

    3. Yes, they are. Both, capital gains and dividend taxes are "automatically" scheduled to increase in January 1st, 2013.
      The tax code is scheduled to go back to pre-Bush tax code, which means that capital gains will automatically rise to 20%, plus the already in the books ObamaCare investment tax of 3.8%, it is an automatic rise to 23.8%. Granted, the implementation of the Buffet rule is on the 2013 budget proposals of Obama and will only become true if Obama wins.
      Same story and worse with dividend taxes. They will automatically be taxed at regular marginal income rates with a top rate reverting to 39.6%, plus the Obamacare investment tax of 3.8%, to a total of 43.4%, representing an increase of 189%.

    4. Am I correct that estate tax also goes up to 55% with 1 million exclusion, and 75% generation-skipping tax on Jan 1?

    5. If you believe that an estate tax hurts economic growth by reducing incentives of parents to work, then don't you have to acknowledge that a lack of an estate tax hurts economic growth by reducing incentives of those waiting to inherit to work?

    6. Estate tax is not about incentives to work, it's about incentives to save in middle age, then to keep assets invested rather than blow them when old. On the kids, income effects are much weaker than substitution effects. Knowing you have a million coming from grandma does not change your incentives for anything more than being nice to grandma.

    7. how can that be? if I know I am about to become rich, doesn't that diminish my desire to work hard to become rich ? I guess I am confused here.

    8. That's an "income effect." Possible. But working an extra hour or saving an extra dollar still has the same payoff. So there is no "substution effect." Your incentives to work are unchanged, only your perception of the benefits and costs is changed.

      Grandma faced a "substitution effect." Each extra dollar she saved used to be a dollar you get. Now every extra dollar she saves only gives you 45 cents. Call the round-the-world cruise lines.

      Generally, income effects seem to be much smaller than substitution effects. That's especially true because most government policies, unlike this example, do not involve poverty stricken bloggers getting millions. The income effects of most of the contemplated tax changes for most people are modest. The substitution effects are much larger.

    9. John, you are correct. Estate tax is due to automatically go up in January 1st to 55% for those over 3 million (it is going up in some measure for all those above 1 million).
      This is the paragon of an "unfair" tax (without forgetting that it is "extremely damaging" to the individual and to the economy).

    10. Thank you for the response. I have been wondering about that issue related to estate taxes for a while.

      It seems that you always advocate policies that encourage saving and dislike policies that discourage it. But surely there must be some point at which people are saving too much and consuming too little. What percentage would people need to be saving for you to support estate taxes?

    11. Whatever they want, facing undistorted prices and interest rates. I don't think it's the job of ivory-tower academics, Federal bureaucrats, or international organization worthies, to decide what the "right" amount of saving vs. consumption is. That's the heart of free-market economics.

    12. yeah :) our main distortion which is unlikely to ever go away is compassion for those who end up saving too little. How does the calculus change conditional on that ?

    13. Yet we have to collect taxes somehow. Certainly some taxes are not distortionary, but rather correct externalities (such as a congestion tax). However, a sales/consumption tax distorts the relative prices of consumption and saving. Is there reason to believe that an estate tax is more distortionary than a sales tax?

    14. An estate tax is probably the least distortionary tax but it also does not take in very much revenue. If you are wanting the best overall taxes to fund necessary government, be efficiently collected, keep distortions low, and keep the government out of the social engineering racket, then sales taxes are the way to go.

  6. In your analysis of Keynesian stimulus and unemployment insurance, you seem to be asserting that whether an economic actor consumes or saves makes no difference to GDP: Keynesian stimulus taxes those who might consume with 60% of their money and spends 100% of it; unemployment insurance takes money from those who might consume with 60% of their money and gives it to those who are likely borrowing constrained and will spend 100% of it. Am I correct that you are asserting this?

    If I recall correctly, you have previously backed up this assertion by pointing out that investment and consumption both equally enter into the equation for GDP, and saving equals investment, so saving leads to GDP just as much as consumption. However, this would seem to suggest that there cannot be a demand shock. If asset prices fall and people consume less, then they are, by definition, saving more, and so increased saving (investment) will compensate for the decrease in consumption. Is this what you believe?

  7. Prof, did you write today's Wall Street Journal editorial?

  8. You state "the overall economy really doesn't care who has the wealth."

    1) That isn't true. Human capital is directly dependent on who has the wealth: food, shelter, education, health care, and transportation are all factors of human capital that are dependent on who has the wealth.

    You keep talking about our sudden fall from long run growth. Look at the positive correlation between that event and income and wealth concentration in the .1%

    2) If true, then why do your friends rush to defend the growing income inequality in this Country, as there is no economic basis for the defense?

    Could it be that old false canard: the poor won't work because they make too much and the rich won't work because they don't make enough.

    Last, you model of incentives is wrong.

    It is been repeatedly shown that compensation is the least important incentive. Why then do you place it first when it ought to be placed last?

    Did you ever read Drucker or anyone else who has thought and written seriously about these kinds of problems.

    85% plus of our economy are services. Getting productivity out of a knowledge worker is entirely separate and distinct from a factory floor. You have been fooled by the nomenclature of software. A toolbar or toolbox on a computer screen is not at all like a blast furnace or assembly line.

    1. If there is a direct correlation between economic growth and wealth inequality then I say Bring on the inequality!

      I want the rich people to make many many more times what they have now, as long as I am also better off.

      Only a person steeped in marxist dogma wants low growth just to spite some rich people.

    2. KyleN

      The correlation between wealth inequality and growth is negative.

    3. Professor, you statement that the fiscal cliff depends on Keynesian multipliers is not true. The fiscal cliff is simple math.

      If you cut gov't spending, you cut gov't consumption by the amount you cut spending. If you increase taxes, you decrease private spending by the amount you increase taxes. Do the math.

      If the gov't doesn't spend $500 billion next year, who is going to make up that spending shortfall?

      What never seems to get through is that the "economy" doesn't have enough spending, it has no way to discern who is borrowing and who is spending. If you borrow $$$ and buy a car, to the economy it is no different if the gov't borrows $$$ and buys and car (or jeep, tank, or airplane), for spending is spending and we need spending. If you won't borrow, well we have two options: (1) the gov't borrows and spends or (2) there is no spending.

      Beyond that, we just learned that, given the irrationality at the heart of free-market economics of markets, we are going to have to learn what the "right" amount of saving vs. consumption is (i.e., the level of private debt). Applying Minsky, there is this guy from Australia (Keen) who has more than a few papers explaining the role of private debt. Going forward, we are going to have to reduce private debt if we are ever going to regain footing.

      Beyond that, the illusion that markets can ever be free is totally false. The key driver of our economy since the 1970s has been oil prices which have never been "free," but are instead external taxes imposed by oil producers, which has gone up 50 fold. Cheap, mispriced goods from China,etc. have been an additional destroyer of wealth.

      Last, and this is what seems to be most beyond your vision, "free markets" drive toward firms becoming too big to fail, from GM, to GE, to our banks, to even Wal-Marts. Even Hayek understood the irrationality of lenders and borrowers over time, albeit he engaged in about every possible form of intellectually dishonesty to avoid the consequences of his admission.

      The Chicago school has been the principal protector of firms getting large enough to become too big to fail, as it has opposed vigorous enforcement of any law intended to promote competition and the last thing you would support is the break up of our large banks.

      When confronted with the firm too big to fail, we have no choice but to bail out, for the cost of failure, like a nuclear bomb, is not contained and all are exposed to the fallout. For example, had GM totally failed, so too would have Ford and Chrysler, for Ford's suppliers were dependent on GM and would have never survived its failure.

    4. I do not think that is proven at all.

  9. Hey,
    I just hopped over to your site via Stumbleupon. Not somthing I would normally read, but I liked your thoughts none the less. Thanks for making something worth reading.

  10. I am not an economist but it seems the the country is leading into economic depression and i still have to consult Ed Butowsky if debt ceiling will be avoided now that the bill had been signed.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.