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Under current law, the US economy will experience a fiscal tightening of unprecedented magnitude at the end of this year. The main drivers include the scheduled expiration of the Bush era tax cuts, expiration of the 2010-11 payroll tax cut, expiration of emergency unemployment benefits, a budget sequester tied to the outcome of the failed Super Committee deliberations, other reductions in non-defence discretionary spending attributable to previously enacted budget appropriations legislation, defence spending reductions tied to a scaling back of activities in Iraq/Afghanistan, and the imposition of some new taxes on individuals imposed by the Affordable Care Act that was passed in 2010.
While the total impact to GDP has been subject to debate, most agree that inaction by Congress will shave at least 3 percentage points off of GDP in 2013. All in, Greenlaw’s team estimates this will shave 5 percentage points off of GDP.
To add some colour to the impact, Greenlaw points to the last time in the post-WWI era when we faced such a cliff. 1969.
Here is another way to look at the potential economic impact. The closest the US has come to experiencing a fiscal tightening of 5% of GDP in the post-WW II period was in 1969. In that situation, President Johnson and the Congress raised taxes by enacting the Revenue and Expenditure Control Act. The goal was to pay for the Vietnam War and try to curb inflation. The legislation imposed a 10% surcharge on individual income taxes retroactive to April 1, 1968 and on corporate income taxes retroactive to January 1, 1968. These surcharges were to remain in effect for two tax years. Telephone and automobile excise taxes were also increased. Moreover, previously enacted legislation imposed a hike in social security payroll taxes at the beginning of 1969. The CBO estimates that the fiscal tightening in FY1969 amounted to 3.1% of potential GDP (on a calendar year basis, it was probably around 3.75% of GDP). Throughout most of 1968 and into the early part of 1969, real GDP in the US was expanding at about a 5% pace and the unemployment rate was below 4%. But, by the end of 1969, the US economy had entered into a recession. No doubt, a series of Fed rate hikes starting in early 1969 contributed to the deterioration in economic activity, but most economists agree that the tightening on the fiscal side was probably the major factor that tipped the economy into recession.
Bottom line: fiscal cliffs are bad news for the economy, and the current one threatens to send us right back into recession.