The Congressional Budget Office
November 08, 2012

CBO: Economic Effects of Policies Contributing to Fiscal Tightening in 2013

Read the full CBO report here

Substantial changes to tax and spending policies are scheduled to take effect in January 2013, significantly reducing the federal budget deficit. According to CBO’s projections, if all of that fiscal tightening occurs, real (inflation-adjusted) gross domestic product (GDP) will drop by 0.5 percent in 2013 (as measured by the change from the fourth quarter of 2012 to the fourth quarter of 2013)—reflecting a decline in the first half of the year and renewed growth at a modest pace later in the year. That contraction of the economy will cause employment to decline and the unemployment rate to rise to 9.1 percent in the fourth quarter of 2013. After next year, by the agency’s estimates, economic growth will pick up, and the labor market will strengthen, returning output to its potential level (reflecting a high rate of use of labor and capital) and shrinking the unemployment rate to 5.5 percent by 2018.

Output would be greater and unemployment lower in the next few years if some or all of the fiscal tightening scheduled under current law—sometimes called the fiscal cliff—was removed. However, CBO expects that even if all of the fiscal tightening was eliminated, the economy would remain below its potential and the unemployment rate would remain higher than usual for some time. Moreover, if the fiscal tightening was removed and the policies that are currently in effect were kept in place indefinitely, a continued surge in federal debt during the rest of this decade and beyond would raise the risk of a fiscal crisis (in which the government would lose the ability to borrow money at affordable interest rates) and would eventually reduce the nation’s output and income below what would occur if the fiscal tightening was allowed to take place as currently set by law.

In August, CBO presented estimates of the budgetary and economic outcomes that would occur under current law and under an “alternative fiscal scenario” that represents a continuation of many long-standing policies and thus a significant reduction in the amount of fiscal tightening next year. To provide additional information about the sources of that tightening and its effects, this report presents estimates of the budgetary and economic impact of the main changes to current law that would occur under that alternative scenario, as well as estimates of the impact of eliminating various other components of fiscal tightening scheduled for 2013.

In order to focus on the short-term impact of policy decisions, the analysis in this report is based on the assumption that the fiscal tightening would be removed and current policies maintained for two years and that the tightening provided by current law would occur thereafter. (In contrast, CBO’s August analysis of the alternative fiscal scenario was based on the assumption that those current policies would be maintained indefinitely.)

On the basis of its analysis, CBO concludes the following:

  • Eliminating the automatic enforcement procedures established by the Budget Control Act of 2011 that are scheduled to reduce both discretionary and mandatory spending starting in January and maintaining Medicare’s payment rates for physicians’ services at the current level would boost real GDP by about three-quarters of a percent by the end of 2013.
  • Extending all expiring tax provisions other than the cut in the payroll tax that has been in effect since January 2011—that is, extending the tax reductions originally enacted in 2001, 2003, and 2009 and extending all other expiring provisions, including those that expired at the end of 2011, except for the payroll tax cut—and indexing the alternative minimum tax (AMT) for inflation beginning in 2012 would boost real GDP by a little less than 1½ percent by the end of 2013.
  • Making all of the changes described in the two preceding bullets—which captures all of the policies included in the first two years of CBO’s alternative fiscal scenario—would boost real GDP by about 2¼ percent by the end of 2013 (as CBO estimated in August). Thus, of the total difference in the projected growth of GDP next year under current law and under the alternative fiscal scenario, about two-thirds owes to changes in tax policies and about one-third owes to changes in spending policies.

  • The estimated economic effect next year of those changes in spending is about half the estimated effect of extending the expiring tax provisions, even though the budgetary impact of the changes in spending is less than one-quarter of the impact of the changes in taxes. The larger “bang for the buck” next year of the spending policies under the alternative fiscal scenario occurs because, CBO expects, a significant part of the decrease in taxes (relative to those under current law) would be saved rather than spent.
  • Extending all expiring tax provisions other than the cut in the payroll tax and indexing the AMT for inflation—except for allowing the expiration of lower tax rates on income above $250,000 for couples and $200,000 for single taxpayers—would boost real GDP by about 1¼ percent by the end of 2013. That effect is nearly as large as the effect of making all of those changes in law and extending the lower tax rates on higher incomes as well (which CBO estimates to be a little less than 1½ percent, as noted above), primarily because the budgetary impact would be nearly as large (and secondarily because the extension of lower tax rates on higher incomes would have a relatively small effect on output per dollar of budgetary cost).
  • Extending both the current 2 percentage-point cut in the payroll tax and emergency unemployment benefits—extensions that are not assumed in the alternative fiscal scenario—would boost real GDP by about three-quarters of a percent by the end of 2013. Making those changes along with making all of the changes in CBO’s alternative fiscal scenario would boost real GDP by about 3 percent by the end of 2013.