Economic Effects of the Sequester

March 7, 2013

Replacing the sequester with tax increases would further damage the economy. Cutting mandatory spending would be the best option, says William McBride, chief economist at the Tax Foundation.

  • The $85 billion sequester cuts will save $1.2 trillion over 10 years and amounts to 2.4 percent of the budget and 0.5 percent of gross domestic product (GDP) per year.
  • Though many employees linked to these federal funds will lose their jobs, as a resource they will be available to drive economic growth in the private sector, if they can find jobs.
  • The sequester exempts the largest and fastest growing part of the budget, mandatory spending, which includes Social Security, Medicare and Medicaid and comprises almost 13 percent of GDP.
  • The sequester splits its cuts between defense-related and non-defense discretionary funding.

Most research suggests that public investment is the type of government spending that is most likely to boost GDP, not transfer payments, yet the sequester cuts discretionary spending and leaves mandatory spending untouched.

  • Tax multipliers suggest that for every dollar the government spends, GDP rises by less than $1, meaning the multiplier is less than one.
  • Temporary defense spending has an estimated tax multiplier of 0.4 to 0.5 immediately and 0.6 to 0.7 over two years.
  • Permanent defense spending has estimated multipliers that are 0.1 to 0.2 percent higher.
  • State and local taxes that are directed toward public investments like roads and bridges first add then subtract from GDP, while transfer payments always subtract from GDP.
  • Evidence also suggests that fiscal consolidation based on spending cuts and no tax increases are more likely to succeed at reducing deficits and debt, and less likely to create recessions as compared to fiscal consolidations based upon tax increases.
  • A 1 percent spending cut has no significant effect on growth, whereas a 1 percent tax increase reduces GDP by 1.3 percent after two years.

This suggests that while the sequester will lower the debt and deficit, it is poorly targeted because it does not target mandatory spending. The only worse option, based on the evidence, would be to raise taxes.

Source: William McBride, "Economic Effects of the Sequester and the Proposed Alternatives: What is the Evidence on Spending and Economic Growth?" Tax Foundation, March 4, 2013.

 

Browse more articles on Tax and Spending Issues