Failure in Washington to reach an accord that avoids these additional elements of the “fiscal cliff” would compel us to mark down sharply our forecast for GDP growth in 2013. Absent an accord, and despite offsetting declines in interest rates and commodity prices, GDP would contract in the first half of 2013 and grow just 1.1% over the four quarters of the year. The unemployment rate, rather than trending down towards 7.5% by the end of 2013, would rise to 8.5%.
Following a fall off the cliff, GDP would, as early as 2014, grow faster than under a “grand bargain” and with less debt. That, however, doesn’t make the cliff a bargain. Our simulations suggest that under a “cliff” scenario, the federal primary budget would move into surplus by 2018, and the ratio of debt to GDP could fall below 60% by 2021. However, GDP would be lower and unemployment higher for a decade. This is partly the result of the extra fiscal drag and partly the result of higher marginal tax rates. The lost output would amount to 10% of this year’s GDP, a high price to pay for the inability to manage fiscal policy effectively. The distributional outcome would be different — and likely less desirable — than that associated with a negotiated, balanced approach to deficit reduction.
Parsing the Effects of the Fiscal Cliff
We’re often asked how much of a drag on growth is associated with each of the provisions of current law that usually are described as comprising the fiscal cliff. The table below presents such results for the four quarters of 2013 and the year as a whole in descending order of importance. These simulations were generated with MA/US, our recently updated macro model, assuming the model’s endogenous monetary offset but holding oil prices along the baseline path and making no judgmental adjustments in the model to other financial conditions. Each provision was simulated separately, so the total reported in the table excludes interaction effects between the provisions. The largest two items are — not surprisingly — the expiration of the Bush tax cuts (-1.15 percentage points of GDP growth over the year) and the spending sequester (-0.76 percentage point of GDP growth). At the bottom of the list, the new taxes enacted as part of the Affordable Care Act will subtract less than one-tenth of a percentage point from growth over 2013. In total, the maximum potential hit to growth from the fiscal contraction is 3.4 percentage points over the entire year, but more than 5 percentage points in the first half of the year. Our baseline forecast includes roughly 11/4 percentage points of the total possible hit to growth.
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