For years the Congressional Budget Office (CBO) has been warning that the federal government’s fiscal course is “unsustainable.” And for just as long, Congress has refused to do anything about it, preferring to defer and delay whenever possible. 

The consequences of congressional irresponsibility have been mounting all the while: four years of $1 trillion deficits, a $16 trillion federal debt, and a slew of temporary tax policies. Even routine fiscal decisions have been neglected: For more than three years the Senate has declined to pass a budget, perhaps fearing what an honest assessment of the government’s fiscal situation might show. 

It is easy to see why Congress is so keen to ignore these issues. The biggest single driver of the federal debt is Medicare, which faces $38 trillion in unfunded liabilities and is expected to become insolvent by 2024 under even the most accommodating estimates. Social Security, a program that has been running annual operating losses since 2010, faces $20 trillion in unfunded liabilities. Federal spending on Medicaid is scheduled to double by 2022 under Obama-Care, and defense outlays are set to grow by more than

$100 billion during the same period even if proposed “cuts” take effect. The long term gap between spending and revenue is a problem that affects nearly every piece of the federal government, and as CBO Director Douglas Elmendorf said in 2010, it “cannot be solved through minor tinkering.”

This fiscal Jenga tower starts to come crashing down on January 2, when inaction-as-usual will suddenly become a major policy decision. Starting on that day, several of Congress’ kick-the-can games are scheduled to end: A temporary payroll tax cut expires, raising taxes by $95 billion if it is not extended; an estate tax cap disappears, multiplying the number of Americans hit by the tax tenfold; and the income tax rates that were reduced under President George W. Bush return to their 2000 levels. According to an October study by the Tax Policy Center, that last change would affect 90 percent of American households, with average marginal tax rates jumping by five percentage points on labor earnings, seven percentage points on capital gains, and 20 percentage points on dividends. 

At the same time, a series of reductions in planned federal spending will also kick in, thanks to the last round of congressional failure to deal with long-term fiscal problems. The 2011 deal to raise the federal debt ceiling included automatic cuts, a.k.a. “sequestration,” in case a bipartisan committee was unable to settle on a deficit reduction agreement. That committee failed to produce a deal, so as of press time budget cuts totaling $1.2 trillion during the next decade were scheduled to become the law of the land after New Year’s Day.

The combination of sequestration and the expiration of tax cuts has been widely described as “the fiscal cliff.” Unless Congress acts at the last minute, between the November 6 elections and New Year’s Eve, the federal budget may go flying over the ledge—and possibly take the nation’s economy with it. 

The CBO warned in August that the fiscal cliff is apt to cause a recession. Credit rating agency Standard & Poor’s already has downgraded the U.S. government’s rating, and its competitor Moody’s has said it may follow suit if Congress does nothing to prevent the scheduled tax hikes and spending cuts. Yet avoiding the cliff comes with risks of its own. With deficits at record levels and the federal debt continuing to pile up, failing to address runaway spending would keep the U.S. on an unsustainable fiscal course, with the possibility of a debt crisis looming on the horizon. There are no happy choices. 

No matter what Congress does, backing away from the cliff is not going to be easy. “We are at the fiscal endgame,” Reagan administration budget director David Stockman told Bloomberg News in July. “From here, it’s going to be chaos.” 

So what should Congress do about the fiscal cliff? reason asked a group of experienced budget policy watchers to explain what the problems are, what we can do about them, and what might happen if we don’t. —Peter Suderman

The Worst of Both Worlds

Charles Blahous

Without legislative action, millions of Americans’ tax bills will suddenly rise and federal spending will be suddenly cut. Many economists believe that allowing all this to happen simultaneously will have severe adverse economic effects, possibly plunging the nation back into recession.

We are in this situation primarily because elected officials have become addicted to inserting “sunset” provisions into laws they don’t actually intend to terminate. This is a classic game-theory conundrum in which the players all face incentives to do the wrong thing, despite knowing that the end result is bad for everyone. 

Political pressure and congressional “pay-go” rules, which require revenue increases or cuts elsewhere in the budget to offset new spending or tax reductions, serve as impediments to laws that transparently add to the deficit. So instead of admitting that many policies we favor do add to the deficit, we pretend that they will only be with us briefly and that their budget effects can be painlessly counteracted with minor offsets.

The result is the worst of all policy worlds. Any positive economic effects of tax relief and government spending are undercut, as both taxpayers and beneficiaries lack certainty about whether, when, and how existing policies will be extended. Meanwhile we have a false picture of our fiscal situation, which forces government scorekeepers to keep two sets of books: one for what current law says and another representing their predictions of what Congress will actually do (namely, keep adding temporary extensions to allegedly sunsetting laws). 

The president, whoever he is, would do the nation an enormous service if he began his term by leading a successful bipartisan effort to end this proliferation of temporary policies. Any further short-term extensions of these laws should be coupled with realistic permanent schedules to replace them. The worst possible scenario, which some analysts have advocated, would involve doing the opposite on both counts: suffer the economic damage from going over the fiscal cliff, only to follow that up with yet another round of temporary “mitigating” policies. 

Although it will be extremely difficult for the parties to reach long-term agreements, it is in their mutual interest to do so, since both major parties’ preferred policies are persistently undermined by current practices. Long-term schedules for income tax rates and Medicare physician payments eventually will emerge one way or another; it is better for this to happen according to a coherent long-range plan than through a series of stopgap measures. There will never be a better time to negotiate such an agreement than at the start of a new presidential administration.

While many existing policies should simply be made permanent, there is one that should be immediately terminated: the Social Security payroll tax cut of 2011−12, a prototypical example of shortsighted policy. Elected officials hoped this cut might give the economy a quick shot in the arm, but they did not want to cut the benefits that the tax finances. So they incorporated a provision to subsidize Social Security from the general fund, carelessly ending decades of bipartisan commitment to the principle that Social Security benefits should be fully earned and that the program should pay its own way. The year following a presidential election is the time to leave such temporary gimmicks behind and to adopt a new economic approach based on long-term stability and consistency.  ρ

Charles Blahous is a research fellow at Stanford University’s Hoover Institution and a public trustee for the Medicare and Social Security programs. 

How to Make a Bad Recovery Worse

James Pethokoukis

During the last four years, Washington has conducted an audacious experiment: take an economy suffering its worst downturn in nearly a century and see what happens when you hit it with loads of new taxes and regulations (while threatening even more) while boosting debt to growth-crippling levels. The result? The weakest post-recession economic recovery in the history of the United States.

Now it’s time for the second phase of the experiment: take an economic recovery that’s grinding along just above stall speed and slam it with roughly $800 billion—about 5 percent of gross domestic product—in tax hikes and cuts to planned government spending. The result? Probably catastrophic.

Before delving into recessions future, let’s take a look a recessions past. The only comparably severe bout of “fiscal tightening” since World War II occurred in 1968, when Washington tried to pay for the Vietnam War while cooling an overheated economy with an across-the-board individual and corporate income tax surcharge. That tax hike, along with some spending cuts, amounted to 3 percent of GDP. Growth slowed sharply. By the end of 1969 the economy had entered a mild recession that would last until November 1970.

The big problem with that strategy this time around is that the economy isn’t what it was in 1968, when growth was at 5 percent and unemployment sat below 4 percent. As a recent Citigroup analysis puts it, “Unlike that earlier period when tightening was designed to be countercyclical and stabilizing, the approaching fiscal cliff would reinforce prevailing weaknesses and fragilities, both in the United States and in the global economy more generally.”

Even a mild recession in 2013 could push unemployment above its Great Recession high of 10 percent. And there is the possibility of creating a disastrous feedback loop if the U.S. recovery should falter while the rest of the global economy, particularly in Europe and China, is already cooling.

One simple goal should guide Washington’s approach to the fiscal cliff: push resources from the public sector to the private sector. That means gradually reducing spending as a share of GDP, as in the 1990s, coupled with pro-growth tax reform, as in the 1980s. Washington needs to signal markets that it is serious about both reducing the deficit and boosting growth, without which America will never escape the debt trap, much less put millions of Americans back to work.  ρ

James Pethokoukis (james.pethokoukis@aei.org) is the Money & Politics blogger at the American Enterprise Institute. 

Sequestration Is Only the First Step

Veronique de Rugy

When it comes to addressing our debt problems, there are no adults in the room. Democrats don’t want spending cuts, but they want to raise income taxes on top earners. Republicans want to cut nondefense spending, but they want to increase defense spending while keeping taxes at current levels for at least one year. But with four years of trillion-dollar deficits, a debt-to-GDP ratio of 100 percent, and entitlement costs that will soon consume half the budget, not cutting spending is no longer an option. 

That’s why the sequestration cuts are only a start. Indeed, they aren’t really “cuts” at all. According to the CBO, without sequestration, discretionary spending would grow from $1.05 trillion to $1.23 trillion between 2013 and 2021. With sequestration, it will instead grow from $1.05 to $1.15 trillion. 

That means going through with sequestration is just the beginning. It won’t make a dent in the size of our debt. More cuts will be needed in the near future.

Yet both sides oppose the sequestration they agreed upon. Republicans, in particular, insist that cutting military spending would kill 1 million jobs and shrink the economy significantly. We should take these claims with a grain of salt. Some jobs would be lost as a result of the cuts, but almost certainly not as many as the defense industry claims. What’s more, some of these job losses will be offset by increased output in other sectors as resources shift. Either way, the Department of Defense isn’t a jobs program and shouldn’t be treated as one. 

The Democrats’ call for tax increases on the rich alone, meanwhile, should be understood more as political posturing than a serious proposal. Even if income taxes on all earnings levels could be raised back to Clinton-era levels without hurting the economy, the resulting revenue would not be enough to address our future debt problem. 

Still, another temporary extension of the tax cuts would merely add uncertainty to an already gloomy economic situation. Furthermore, convenient temporary tax policies are precisely the sort of politically expedient decision that has put the country in this state of perpetual fiscal cliffs.

So what should Congress do? The United States has a debt problem. Economists have looked at the different ways other countries have tried to address similar debt crises. A review of the literature reveals that the most promising way to shrink the debt without killing the economy is to cut spending and not increase taxes. 

The good news is that Congress already has passed a law that would at least cut the growth of spending. It is called sequestration. Allowing it to take effect is the least Congress can do.  ρ

Contributing Editor Veronique de Rugy (vderugy@gmu.edu) is a senior research fellow at the Mercatus Center at George Mason University. 

Kick the Can, Again

Tad DeHaven

One of the few things Congress is good at is avoiding problems by kicking the can down the road. The Party of Military Keynesianism (Republicans) and the Party of Domestic Keynesianism (Democrats) are anxious to avoid the sequestration cuts they already voted for. With the Bush tax cuts and a raft of other tax cuts scheduled to expire at the same time, angst is ratcheting up on both sides of the aisle. 

The CBO says the combination of spending cuts and tax increases would push the economy back into recession and increase the unemployment rate to 9 percent. These projections have given Republicans ammunition to resist tax increases and military spending cuts. They have given Democrats an excuse to oppose spending cuts while supporting the continuation of tax cuts for all but the “wealthy.” Consequently, both sides have been able to continue pontificating about the need to avoid a future debt crisis while doing nothing to prevent one. 

My bet is that Congress will once again kick the can down the road; the real question is how. The GOP might capitulate on taxes to protect military spending. Or Democrats might capitulate on taxes to avoid substantive spending cuts. Another darkly amusing possibility is a temporary continuation of current policy in exchange for yet another deficit reduction commission. No matter which of these three scenarios plays out, it will only be a matter of time before Congress has to deal with Fiscal Cliff II.  ρ 

Tad DeHaven (tdehaven@cato.org) is a budget analyst at the Cato Institute and co-editor of downsizinggovernment.org.

Fear the Regulatory Cliff, Too

Susan Dudley

Much attention has been focused on the economic risks posed by the approaching fiscal cliff. Yet fiscal policies are not the only way the federal government diverts private-sector resources to achieve its own goals. Regulations, which dictate what employers, workers, and consumers can and cannot do, can have as large an effect on the economy as taxation and spending. Americans should be aware that we are headed for a regulatory cliff as well. 

As Sen. Rob Portman (R-Ohio) highlighted in an August op-ed piece for The Wall Street Journal, the Obama administration has explicitly postponed several multibillion-dollar regulatory decisions until after the election. These include environmental regulations tightening ozone air quality standards and cooling water intake standards at electric utilities, Department of Labor rules on investment advice, Department of Transportation regulations requiring rearview cameras in new vehicles, and numerous regulations resulting from the Dodd-Frank and Affordable Care acts.  

The Obama administration published a record-setting average of 63 final rules with impacts of $100 million or more annually in its first two years. The 2010 midterm elections seem to have imposed some restraint on its regulatory agenda, with the pace slowing to an annual average of 44 major rules since then. (That is about the same as the average of 45 major rules per year issued by Presidents George W. Bush, Bill Clinton, and George H.W. Bush, although much higher than President Reagan’s 23.) 

The recent restraint is just the calm before the storm, however. The Office of Information and Regulatory Affairs (OIRA), which reviews all significant executive branch regulations before they are published, has a large backlog. While OIRA typically reviews regulations in fewer than 60 days on average, currently more than 70 percent of the regulations under review have been sitting at OIRA for longer than 90 days, and about 10 percent have been there for more than a year. This backlog is unprecedented. 

Not only are fewer regulations emerging from OIRA review, but they are being submitted at a pace that is about half of that during Obama’s first three years.  Given that the White House has not published a semi-annual agenda of upcoming regulations since the fall of 2011, it seems likely we are witnessing an effort to hold off on controversial regulations until after the presidential election. 

Regardless of the election’s outcome, a regulatory cliff is coming. If Mitt Romney wins, bipartisan history suggests we will see a midnight rush of lame-duck Obama regulations. If President Obama wins a second term, we can expect to kick off four years of unchecked regulatory growth. Like the fiscal cliff, either scenario could alter how Americans live and work for a long time to come.  ρ 

Susan E. Dudley (sdudley@gwu.edu) is director of the George Washington University Regulatory Studies Center and a research professor in the Trachtenberg School of Public Policy and Public Administration. Her new book, Regulation: A Primer, co-authored by Jerry Brito, is available on Amazon.com in paperback and Kindle formats.

A Challenge and an Opportunity

Maya MacGuineas

Washington has yet to find a way of avoiding the fiscal cliff without adding to our mountain of debt. Political gridlock could lead to massive, abrupt, and across-the-board spending cuts and tax increases, which would throw the economy back into recession. Worse, lawmakers might agree to waive deficit reduction measures, in which case our debt would continue to accumulate, our long-term growth prospects would slow, and we would eventually hit a fiscal crisis.

The United States can and must do better. The fiscal cliff is a challenge, but it is also an opportunity to re-form our biggest spending programs and our outdated tax code. By replacing the sudden and mindless measures of January 1 with a gradual and thoughtful plan to move the debt onto a downward trajectory, we can place the economy on an upward one.

Such a plan must make real choices, carefully balancing short- and long-term economic growth and aligning both sides of the budget closer to the core values of the American people. It should start quickly but phase in slowly to give the economy time to recover, while restoring confidence in our ability to pay back our debt. It should cut spending on programs we don’t need while protecting important investments in our future. And it should reform the tax code to make it simpler, fairer, and more pro-growth.

Of course, writing such a plan in its entirety is a heavy lift in the short time remaining before the new year. But if policy makers cannot write the whole plan, they should at least be able to agree on a framework, including how much deficit reduction comes from revenue, health care, and other parts of the budget. To be credible, such a framework should have a down payment of deficit reduction we can enact before the year is over, a time line and process for enacting the remaining deficit reduction, and some sort of enforcement mechanism to ensure that the savings materialize.

Going off the fiscal cliff would be a disaster, no question. But the real tragedy would be failing to do something substantial to address our debt when we have the chance. If we can’t get our debt under control, it is not only we who will suffer but future generations as well.  

Tax Cuts Don't Work Without Spending Cuts

Matt Mitchell

It seemed like such a good idea. There weren’t 60 votes in the Senate for George W. Bush’s tax cuts, so the President used a procedural maneuver to get them passed with a simple majority. There was just one hitch: the procedure required that at the end of 2010, rates would go back up. Ten years have quickly come and gone; so has the two-year extension worked out by President Obama and Congressional Republicans in 2010. And now, staring down the barrel of a “fiscal cliff,” temporary tax cuts don’t seem like such a good idea anymore.

Economists of all stripes worry that a precipitous tax hike—especially in the middle of a weak recovery—could have devastating economic consequences. Among Keynesians, the concern is that the tax increase will sap consumers’ purchasing power, weakening aggregate demand. Among real-business cycle economists, the worry is that higher marginal rates will diminish the incentive to work, save, and invest. And since investment decisions are made with an eye toward the long run, it is even possible that the scheduled tax increase has been undermining the potency of these tax cuts for years.

The truth is that even if the tax cuts weren’t automatically scheduled to end someday, they were never believable as sustainable fiscal policy. That’s because no one in government even attempted to bring spending in line with the lower revenue. In fact, Washington went on a spending binge shortly after taxes were cut: from 2001 to 2009 federal spending leapt from 18.2 to 25.2 percent of GDP. This was the largest such increase in any 8 year period since WWII.

This episode should have advocates of limited government asking themselves an important question: are tax cuts without spending cuts good for the cause of limited government? Decades ago, Milton Friedman answered this question with a resounding yes. Cut taxes, he counseled, and starve the beast. With less revenue, spending will fall too. Tax cutters from Ronald Reagan to George W. Bush have been convinced of “starve the beast” ever since.

But there is another Nobel laureate with free market bona fides who begs to differ. James Buchanan, a founding father of public choice economics—which uses the tools of economics to shed light on the incentives of policy makers—has long questioned “starve the beast.” When politicians are legally and politically permitted to run deficits, he warned, they will simply fund government by borrowing. In this case, tax cuts give voters the illusion that government spending is cheap. And with government seeming less-costly, voters will be happy to have more of it.

A few years ago, economist Andrew Young of West Virginia University tested the two hypotheses using 50 years of federal data. His findings suggest that on this one, Buchanan may have had it right: Tax increases, rather than tax cuts, actually seem to be associated with less government spending. In his words, the findings suggest that “the electorate has to be clearly presented with the bill to recognize the cost of government.” Berkeley economists David H. Romer and Christina Romer recently corroborated Young’s finding using a different dataset and different techniques.

Come the beginning of January, voters will see more of the bill than they are used to. Those of us who want to keep that bill low need to be willing to buy less government. And that means cutting spending and taxes. 

Matthew Mitchell is a senior research fellow at the Mercatus Center at George Mason University and the lead scholar on the Project for the Study of American Capitalism

The Wrong Way to Reduce the Deficit

Marc Goldwein

I like to tell people that there is no one right way to reduce the deficit. But there is a wrong way, and with the fiscal cliff, Congress appears to have found it. Federal debt is on an unsustainable path, and there is no question that we must address it. Yet deficit reduction cannot just be a bean counting exercise. It must balance our economy's short- and long-term growth needs.

Going off the "fiscal cliff" at the end of the year by allowing the income tax rate cuts first passed under President Bush to expire and allowing the so-called sequester to reduce spending across-the-board would reduce the deficit. But it would also throw the economy into a double-dip recession. According to the Congressional Budget Office, in fact, going off the fiscal cliff would shrink the economy by almost 4 percent in the first quarter of 2013 and drive the unemployment rate up to 9.1 percent in the next year.

These abrupt and reckless policies would severely dampen any hope for short-term economic growth that we need to strengthen the economy and put people back to work. An intelligent plan would do more to protect short-term growth by phasing in fiscal restraint gradually to give markets, businesses, and households confidence that we will pay down our debt and certainty over how it will be done.

In the long run, doing nothing to avoid the fiscal cliff would reduce federal debt. But it would also to provide a policy mix favorable to smart economic growth. Going over the cliff would raise marginal tax rates and cut investments thereby stifling long-term growth, and it would do so without addressing the real drivers of our debt. To be sure, continuing to let the debt rise uncontrollably would be the worst long-term outcome; but going over the cliff is certainly not the right way to promote long-term growth.

A deal to replace the cliff should not only protect the fragile recovery in the short-term, but prioritize growth in the long-term. It should cut spending which inhibits or does little to help growth while protecting important investments that are critical to long-term growth. It should reform the tax code to lower corporate and individual rates, but still raise more revenue through broadening the base. Finally, it should encourage a stronger, larger workforce through gradual increases in the retirement age.

Short and long-term growth policies do not have to be at odds with short and long-term deficit and debt reduction. Both can and should be included as the basis for a bipartisan solution to prevent the fiscal cliff and fix the debt. 

Marc Goldwein is the senior policy director of the Committee for a Responsible Federal Budget.