U.S. Fiscal Policy: Avoiding Self-Inflicted Wounds

IMF Blog, August 8, 2012

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Author: Gian Maria Milesi-Ferretti
Date: August 8, 2012
Context: U.S. and global economy still recovering from the global recession that began in 2008. Two potential "self-inflicted wounds" could hit the U.S. economy at the end of 2012: the fiscal cliff and the debt ceiling.

Key expiration date: January 1, 2013.
Components set to expire or take effect on January 1, 2013:
- Payroll tax break expiration.
- Expiration of the Bush tax cuts (enacted in 2001 and 2003, and extended for two years at the end of 2010).
- Exemptions on the Alternative Minimum Tax set to expire.
- Across-the-board spending reductions (sequestration) for defense and nondefense spending agreed as a contingency if the "Super Committee" failed to approve deficit-reduction measures.
Cause: The Super Committee did not produce a deficit-reduction plan, triggering the scheduled deep spending cuts.

Estimated fiscal impact: remove about $700 billion from the U.S. economy next year—over 4 percent of GDP.
Composition: higher taxes contributing about three quarters of the total.
Projected macroeconomic outcomes:
- Reduce growth to about zero on an annual basis in 2013.
- The economy would most likely fall into a recession early next year (2013).
- Negative impact could begin earlier in 2012 due to heightened uncertainty leading consumers, businesses, and government agencies to hold back spending.

The U.S. recovery is tepid and unemployment remains elevated following the 2008 financial crisis.
Monetary policy is constrained because interest rates are already extraordinarily low.
A weakening world economy would provide limited external demand support for U.S. goods and services.
Both higher taxes (reducing private spending) and steep government spending cuts (reducing public demand) would subtract from growth.

Principle: The U.S. needs to raise taxes and cut spending, but should do so gradually, without sapping the economic recovery.
Short-term fix (in principle): reach a political agreement to ensure that tax increases and/or spending cuts are carried out by only a modest amount next year (2013).
Credibility-enhancing measure: pair a modest near-term adjustment with a credible plan to gradually raise taxes further and limit the growth of spending so that U.S. public debt stops growing faster than U.S. GDP.
Political reality: significant differences exist across the U.S. political spectrum, but there is some common ground and a number of bipartisan plans have been put forward.

Timing: In late 2012 or early 2013 the U.S. federal government will again reach a statutory borrowing limit and will not be able to issue additional debt unless the ceiling is raised.
Why it matters:
- The federal government is spending considerably more than it collects in taxes.
- Spending and tax collections are not synchronized, creating cash-flow financing needs.
Risks of not raising the ceiling in time:
- The government would need to cut spending drastically, curtailing important government functions with detrimental effects on output and employment.
- The mere possibility that the government might have to delay a payment on a bond could unsettle financial markets.
Past experience: Last summer an acrimonious debate delayed lifting the debt ceiling until the last minute; interest rates on Treasury bonds did not rise, but financial markets suffered and uncertainty and a decline in faith in the political system reduced consumer and business confidence.
Recovery of confidence: It takes a lot of time to regain confidence and trust, but one rash action can quickly undermine them.

Both the fiscal cliff and the debt ceiling represent avoidable, self-inflicted risks that could derail the fragile U.S. recovery.
Policymakers should aim for gradual, credible fiscal consolidation that stabilizes debt dynamics without causing a sharp near-term contraction in demand.
Avoiding last-minute, acrimonious confrontations over fiscal policy and the debt limit is important to preserve market confidence and support economic recovery.

Gian Maria Milesi-Ferretti, August 8, 2012