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

_IMF Blog, August 8, 2012_

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**Canonical URL:** [U.S. Fiscal Policy: Avoiding Self-Inflicted Wounds](https://www.imf.org/en/blogs/articles/2012/08/08/u-s-fiscal-policy-avoiding-self-inflicted-wounds)

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## Bibliographic details
- Authors: Gian Maria Milesi-Ferretti
- Published: August 8, 2012

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### Overview
- 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.

### The fiscal cliff: description and mechanics
- 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.

### Economic magnitude and projected effects
- 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.

### Why the impact would be severe
- 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.

### Policy options and recommendations for the fiscal cliff
- 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.

### The debt ceiling: timing, mechanics, and risks
- 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.

### Conclusion and policy takeaway
- 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*

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## Content in this bundle

- **Country Report**
  - [Country Report (Markdown version)](/external/pubs/ft/scr/2012/cr12213.pdf.md){rel="alternate" type="text/markdown"}
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---

## References

- [still recovering](http://www.imf.org/external/pubs/ft/survey/so/2012/CAR070312B.htm)
- [U.S. economy](http://www.imf.org/external/pubs/ft/survey/so/2012/CAR080212A.htm)
- [financial crisis](http://www.imf.org/external/pubs/ft/fandd/2012/06/rowe.htm)

_Source: https://www.imf.org/en/blogs/articles/2012/08/08/u-s-fiscal-policy-avoiding-self-inflicted-wounds_