02 October 2012

Why We Will Leap Off the Fiscal Cliff (And Why It's Not That Bad)

We're going over the fiscal cliff in January. As painful as it will be, it might be the only way that  Washington will begin deficit reduction.

Federal taxes as a percentage of GDP are the lowest they've been since you started paying taxes, and federal spending as a percentage of GDP is the highest. The result is a trillion dollar deficit and weaning an economy of that mix of tax breaks and stimulus spending is like weaning a junkie from heroin. There is no graceful way to do it.

This massive deficit is simply not sustainable but there is no way that Republicans will agree to raise taxes a single dime and no way that anyone - Republican or Democrat - could propose a trillion dollar spending cut without committing political suicide and gutting long-established programs.

Which brings us to our fiscal cliff, which will automatically cut discretionary spending by about 10% and raise taxes on the typical family by about $3,446

For the last few years, taxes as a percentage of GDP have been 15-some percent. From 1960 to 2008, they averaged 18.1%, and ranged from 16.1 to 20.6%. We're at a new low for taxes.

During that same half century, 1960 to 2008, federal spending as a percentage of GDP has averaged 20.2%, ranging from 17.2 to 23.5%. The last few years it's been 24 to 25%. Again, to put it simply, we're at a new high for spending.

It's no mystery that the lowest taxes combined with the highest spending in half a century have created a record deficit. 

Until taxes are sharply increased, Republicans' call for lower taxes makes about as much sense as legislation to protect the unicorn from extinction. However, if spending is slashed and taxes are hiked, the usual arguments out of Washington might actually make sense again. An automatic tax hike might pave the way for reasonable, targeted tax cuts. Automatic spending cuts might make proposals for new spending in target areas a great idea. Falling off the fiscal cliff may not knock sense into the usual debaters but it might re-align their arguments from ridiculous to marginally plausible.

This fiscal cliff is likely to cause another recession. Whether it is mild or severe will have as much to do with Europe and China as our own economy. This brings risk to the economy but it seems as though the graceful exit from fiscal madness is closed for repairs. Let's just hope that the crash at the bottom of the cliff doesn't include a gratuitously spectacular explosion.


Steve Finnell said...

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Thomas said...

An invasion of Iran (or at least an awesome bombing display) would provide a nice distraction from our troubles, inject a little Patriotic Fervor into our veins, and give the military a good cover to protect their budget.

gabby57 said...

Even though GDP seems to be the standard to cite regarding taxes and spending, I find it hard to get excited about the ratio of taxes or spending relative to GDP when the connection seems so ambiguous. (at least to me) There are at least 3 methods for calculating GDP and the “Production Method” appears to be the standard.
So as I understand it, as I get more productive and if my income/taxes do not increase at the same rate because of market conditions, the tax to GDP ratio will decline. If we have to use a ratio to GDP as an indicator, it seems to me that more reasonable connection would be to use the “Income Method” for calculating GDP when discussing the ratio of taxes. At least taxes are relative to income.
Again, the correlation between Federal spending and GDP seems to be tenuous. If Federal spending is static but Consumer spending is down, Business is investing in other countries rather than in the US, and imports are greater than exports so that it subtracts from the GDP; how is this dynamic an indication of excessive spending? Again, shouldn’t spending be more of issue of income? At least the Income method of determining GDP has some correlation to taxes.
Maybe a better ratio is taxes to median income for personal income and taxes to EBITDA for businesses. It is hard to identify a valid ratio for spending without making a “judgment” about spending. We are not going to not pay for our security and other required Gov’t services (whatever that means to you). Call those “above the line expenses. Other discretionary spending (again, whatever that is) would be “below the line”. Then the ratio of tax percentage to below the line expenses might indicate a requirement for some course adjustment.

Ron Davison said...

Thomas - plus you don't want to change horses in midstream so a war can help with re-election prospects.
Gabby - I think that % of GDP is a decent indicator of general levels of spending, a first level sanity check as to whether the origins of a deficit are unusual levels of spending or taxes. GDP includes things like imports and exports and income from capital gains and profits, so we'd want the whole enchilada. GDP probably works better than GNP given that foreign income usually gets taxed outside the country, no?