An Economic Guide to Cliff-Diving

December 17, 2012

The fiscal cliff is looming over the United States as lawmakers continue to debate about the best way to avoid tax increases and spending cuts, say Douglas Holtz-Eakin and Cameron Smith of the American Action Forum.

If a deal is not reached:

  • The tax increases are nearly $400 billion.
  • Spending cuts are likely to total $145 billion.
  • In total, it is likely to be about 3 percent of gross domestic product (GDP).

These cuts will hurt low-, middle- and high-income individuals across the board. However, the debate about the financial impact of the fiscal cliff tends to overlook the effect it will have on the real economy and financial markets.

The effect that the fiscal cliff has on the real economy is dependent on the multiplier.

  • Some estimates say the multiplier is about three, so for every $1 tax hike, there is $3 lost in GDP.
  • This means that going over the fiscal cliff would result in economic decline of $1.6 trillion, or 10 percent of the GDP.

The effect the fiscal cliff will have on the financial markets is also a very important consideration for lawmakers. Because markets can respond instantaneously, the mere perception that the government is going over the cliff can set off a chain of events. For instance, equity markets could fall and the riskiness of various classes of debt will be reevaluated.

The impact that the fiscal cliff has on financial markets will also increase the multiplier. And because markets are still recovering from the recent financial crisis, this kind of impact is going to shake confidence and prolong economic recovery.

Some argue that the markets won't respond strongly to the fiscal cliff because they'll perceive efforts to reverse tax hikes and spending cuts in the next year. However, it is unlikely that markets will have that kind of confidence considering the problem that lawmakers are having in coming to an agreement now.

Source: Douglas Holtz-Eakin and Cameron Smith, "An Economic Guide to Cliff-Diving," American Action Forum, December 2012.

 

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