Unless Congress and the Obama administration reverse a number of tax increases and spending cuts that will automatically go into effect beginning on Jan. 1, there will be severe economic ramifications for both the United States and the world.
U.S. Federal Reserve Chairman Ben Bernanke has referred to the changes, which include an estimated $100-billion (U.S.) in spending cuts and a 20-per-cent increase in tax revenue, as a "fiscal cliff" that will send the U.S. economy into free-fall.
Although tax increases and spending cuts are needed in the long run to reduce the deficit, a weak United States does not have the capacity to absorb such changes – the root of the rhetoric over the fiscal cliff.
U.S. consumer spending is already weak; taking dollars out of the hands of the general public will only escalate the problem. Changes, such as raising the capital gains tax rate to 20 per cent from 15 will cause investment spending to decrease substantially. Failure to deal with the fiscal cliff will have dramatic economic consequences, as the Congressional Budget Office estimates that U.S unemployment will rise to over 9 per cent and could reduce GDP in the fourth quarter of 2013 by as many as three percentage points.
Canada would not be immune to the effects either: TD Bank estimates the real GDP growth could decline by as much as 1.8 percentage points in 2013.
While the U.S. tax increases will cause dramatic economic problems, Mr. Bernanke's characterization of the fiscal problem as a cliff lacks accuracy. A cliff is a poor metaphor, as the economy does not simply collapse on Jan. 1. Many of the spending reductions will not occur immediately and it will take time for the additional tax revenue to flow to the government.
Alternative metaphors, such as walking with a backpack full of weights or going down a water slide have been proposed to better describe slow deterioration of economic conditions as consumers and businesses spend less. But "fiscal waterfall" hardly inspires terror.
As an economist, Mr. Bernanke was likely thinking of rational expectations theory when he came up with the fiscal cliff metaphor. Under rational expectations, consumers' spending plans are altered by beliefs about the future. If taxpayers believe that income taxes will go up in the future, they will reduce spending today and increase their savings. This reduction in spending has immediate effects on the economy, even if taxpayers do not feel the bite of the tax hikes until the future.
However, rational expectations do not explain why the cliff would occur on Jan. 1. If we believed that a solution was not possible, we would not wait until the first day of 2013 to start saving. And on Jan. 1, we would not start immediately saving more unless we thought the problem was likely not to be solved in the future.
Mr. Bernanke had the right intention in describing the problem as a cliff, as dramatic language helps motivate action. But the fiscal cliff is only a cliff if taxpayers believe the problem cannot be solved. This is good news for the Obama administration and Congress, as they do not need to have a solution implemented by Jan. 1. Convincing taxpayers and markets that a solution is on the way is more than enough.