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set to expire, including provisions that extended reductions in tax rates and expansions of tax credits and deductions originally enacted in 2001, 2003, or 2009.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..............