Looming Fiscal Cliff?

From time to time, journalists and commentators refer to a looming fiscal cliff. Most of us don’t know what this is or what it means. The fiscal cliff entails the sunsetting of many of the tax laws put into place during the Bush years and renewed for the past two years as well as some of the legislation enacted during the Obama administration. According to the Congressional Budget Office, here’s a short list of the most significant provisions and some possible effects should these not be renewed by Congress.

Several provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 may expire, including the extension of reduced tax rates and expanded tax credits, as well as lower payroll taxes for Social Security. Also on the block, changes in Medicare payments to service providers; lowering the amount sharply. Finally, provisions to enforce mandatory budget constraints will also go into effect.

This will result in a reduction of the deficit for the 2013 fiscal year, but it will also most likely lead to another slow down in economic activity. This may even result in another recession, with unemployment rising above 8% and maybe even reaching 9%.

If most or all of these provisions are renewed (or delayed in the case of many of the provisions of the Budget Control Act), the deficit will again be more than $1.0 trillion, though with a growing economy, this should be a lower percentage of GDP. The Congressional Budget Office predicts that this deficit and debt levels will be unsustainable as output and income would be reduced in the long run while deficits would continue to average about 5% of GDP.

An interesting note: over the last 40 years, tax receipts and revenues have averaged 18% of GDP while outlays (expenditures) have averaged 21% – so we’ve been running an average 3% deficit annually. This can be directly tied to the growth in the federal debt to over $16.0 trillion. To halt this trend, some fiscal conservatism is in order. How to accomplish this is up to our elected officials. Stay tuned for a post-election update complete with prognostications from some talking heads!

Mary Wladkowski, PhD, CFA
Assistant Professor, Finance
Chair, Business Administration Department