CBO analysis shows ‘fiscal cliff’ will sharply reduce long-term deficits but lead to a recession in 2013

The latest analysis by the non-partisan Congressional Budget Office concluded that the ‘fiscal cliff’ – the combination of steep budget cuts and expiring tax breaks set to take effect on Jan. 1, 2013 – will significantly reduce the federal deficit and set the country on a sustainable long-term fiscal path but will likely result in a recession and higher unemployment rates next year. 

The CBO also announced that this year’s federal deficit will exceed $1 trillion for the fourth consecutive year and that federal debt will make up 73% of the U.S. economy as measured by its Gross Domestic Product or GDP.

Read more: Transcript: CBO Director Doug Elmendorf on the deficit & ‘fiscal cliff’

Unless Congress takes action, the Bush-era tax cuts, the emergency unemployment benefits, and payroll tax cuts are all set to expire on Dec. 31, 2012. At the same time, the automatic $1 trillion spending cuts to defense and non-defense discretionary spending as mandated by the Budget Control Act of 2011 and a nearly 30% reduction in Medicare physician reimbursement rates are scheduled to take effect on Jan. 1, 2013.

“If allowed to occur, those sharp reductions in federal spending and increases in taxes will lead to a dramatic reduction in the federal deficit, trimming it by almost $500 billion next year,” said Douglas Elmendorf, Director of the Congressional Budget Office. “That would be a significant tightening of fiscal policy and would probably lead to a recession early next year.”

Speaking to reporters today, Elmendorf said economic output would decline by 3% during the first six months of 2013 but would bounce back during the latter half of the year while unemployment rate would increase to 9% next year and remain above 8% through 2014 as a result of the fiscal cliff.

On the upside, the fiscal cliff would dramatically reduce the federal deficit. According to the CBO’s projections, the deficit would be lowered to about $641 billion (or 4% of GDP) in 2013 and ” continue to shrink for several years—to 2.4% of GDP in 2014 and 0.4% by 2018.”

“With small deficits and a growing economy, debt held by the public falls from 73% of GDP in 2012 to 58% of GDP in 2022,” said Elmendorf. This would put the U.S. under a more sustainable and stable fiscal path.

However, should lawmakers in Washington decide to avoid the fiscal cliff by permanently extending the Bush-era tax cuts, maintaining the current Medicare physician payment rates, and preventing the automatic across-the-board sequester cuts from taking effect, then the deficit would, again, exceed $1 trillion next year and “would remain very large throughout the coming decade, averaging about $1 trillion a year” and adding another $10 trillion to the deficit by 2022.

Extending the Bush-era tax cuts for all would add $3.18 trillion to the deficit between 2013 and 2022, and extending other tax credits to stimulate job creation would increase the deficit by $1.05 trillion. Indexing the Alternative Minimum Tax for inflation would raise the deficit by $994 billion. In all, the CBO’s projections showed that maintaining the existing tax cuts and tax credits would contribute $5.2 trillion – or more than half – of the federal deficit in the coming decade.

On the spending side, getting rid of the Budget Control Act’s sequester cuts would raise the deficit by $1.14 trillion between 2013 and 2022. Continuing Medicare’s current physician pay rate would add $311 billion to the deficit over the next 10 years.

Although economic growth would be stronger and the unemployment rate lowered in the short-term, the CBO concluded that averting the fiscal cliff in 2013 would set the country on an unsustainable fiscal path where public debt is projected to grow to 90% of GDP by 2022.

Not only would the “rapidly escalating federal debt” lead to loss of investor confidence and hinder the federal government’s ability to borrow at favored rates in the future, high national debt would crowd out savings and investments – and thereby economic growth – in the future.

“The key issue facing policymakers is not whether to reduce budget deficits relative to those that would occur under current policies. The question is when. The question is how,” said Elmendorf. “At some point, we will need to adopt policies that require people to pay significantly more in taxes, accept substantially less in government benefits and services, or both.”


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