The Reality of the Cliff


Keynesians do not admit to owning this cliff, but they get most of the credit.

The coming increases in taxes is well comprehended.  The CBO, that well known group of Keynesians, predicts that there will be down turn in the economy next year due to these taxes.


The Cliff the Keynesians Built     Link

Temporary tax cuts created the fiscal threat to growth.


'A stimulus program should be timely, targeted and temporary."

—Lawrence Summers, January 29, 2008


Well, well. So the folks who have run U.S. economic policy since 2008 are alarmed about the peril of the 2013 "fiscal cliff." Too bad they didn't worry about that when they were creating the very ledge they now lament.


The latest warning comes from the Congressional Budget Office, which estimated in its mid-year budget outlook Wednesday that the economy will return to recession in 2013 if taxes rise and spending falls on schedule in January. "Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession," say the CBO sachems, "with real GDP declining by 0.5 percent" from this year's fourth quarter to the final quarter of next year and unemployment rising to about 9% from 8.3%.


Yes, a year of falling output would "probably be considered" a recession, especially if you are one of the 9% jobless.


One point to keep in mind is that CBO's economists are as true-blue Keynesians as exist on the planet. Like the Obama White House and Treasury, they believe in the "multiplier" that $1 of federal spending somehow creates $1.50 in greater GDP. Thus they plug large spending cuts into their economic models, and, presto, they find a recession.


One remarkable (and highly dubious) note in the CBO report is that the budget gnomes predict a big surge in tax revenues in 2013—to 18.4% from 15.7% of GDP—despite the recession they also predict. CBO simply doesn't think taxes matter much to taxpayer behavior, so it applies the higher rates to its current predictions of income and pretends revenues will roll in like the tides. But this will be a fantasy if enough Americans find ways to hide their income or work less, or if they simply earn that much less thanks to the recession.


The larger policy point is that this is the fiscal cliff the Keynesians built. The 2008 quote above from Larry Summers, the Harvard economist who later became President Obama's chief economic adviser, sums up the mindset that has dominated policy for most of the last decade and especially since 2008.


Rather than provide predictable, consistent policy for the long term, the Summers-Obama-Geithner-Krugman theory goes that government should jolt the economy with spending and tax cuts that are targeted and temporary. The jolt will drive the economy out of recession, rapid growth will resume, and the wizards of Harvard Yard can then tell us the precise moment when the stimulus can be withdrawn and taxes should rise again.


Or, if the jolt doesn't work, then order up another jolt, which makes the tax cliff even steeper.


The last decade has provided as clear a market test of this proposition as one can get. First, the Bush Administration had to accept a temporary window for its 2001 and 2003 tax cuts to pass the Senate's crazy budget rules. Its tax rebate of 2001 was such an economic bust that without the more ambitious and better designed 2003 tax cut Mr. Bush might not have been re-elected. But even the 2003 cut had to be temporary to pass Congress.


Then came the Summers-George Bush-Nancy Pelosi $168 billion tax rebate and spending stimulus of February 2008. That goosed GDP for a quarter as temporary consumer and government spending showed up in the national accounts, but growth quickly sputtered even before the autumn 2008 financial panic.


President Obama with Treasury Secretary Tim Geithner, left, NEC Director Larry Summers, right, and Budget Director Peter Orszag, far right.

.Then came the $830 billion stimulus of February 2009, followed by other "targeted and temporary" measures like cash for clunkers and the first-time homebuyer's tax credit. GDP rose modestly as the economy recovered, albeit at a historically slow pace considering the depth of the recession. The rate of growth has since sputtered in each of the last three years.


That didn't stop Mr. Obama, who tried still another temporary tax fix after Republicans captured Congress in 2010. He agreed to extend the Bush tax rates for another two years, but only in return for an additional temporary payroll tax cut for one year. When that didn't spur faster growth in 2011, the President demanded and won another one-year payroll-tax extension for 2012. First half GDP growth this year fell again to 1.7%.



So here we are now facing the expiration of all of these temporary measures at the same time. And that's not all. You have to add the higher tax rates that Mr. Obama has proposed in his budget, such as the 30% "Buffett rule" tax rate on capital gains. And don't forget the new 3.8% surcharge on investment income that is part of ObamaCare and also starts in January.


The nearby table compares current tax rates with those that arrive next year with the tax cliff, as well as Mr. Obama's budget proposals and Mitt Romney's tax reform plans. Mr. Romney is proposing an across-the-board rate cut, while Mr. Obama would keep rates the same only for those earning less than $250,000. Everyone else would see a huge tax increase, one of the largest in history.


Republicans are pointing to the CBO report as proof of Mr. Obama's policy failure, and it is. But rather than gawking at the potential for another recession, they ought to explain the folly of "temporary, targeted" tax and spending stimulus. The fleeting tax elixir does little to change incentives to work or invest because everyone knows its impact is temporary. It also creates tremendous uncertainty as expiration nears, which can also harm incentives and growth.


The problem is political, but more important it is intellectual. The Keynesians and their allies who have dominated tax policy for most of the last decade (the 2003 bill excepted) need to be exiled back to Harvard, Princeton and Wall Street. And the Romney-Ryan Republicans need to understand and not repeat the Bush mistakes of 2001 and 2008.


Instead of "timely, targeted and temporary," tax policy should include lower rates (and fewer loopholes) that are applied as broadly as possible and are permanent. These were the principles that guided the Reagan policy of the 1980s, and they need to be revived.



Your thoughts?