The Fiscal Cliff is all they talk about on some of the business channels now, at least by my infrequent watching of the channels. Fiscal policy involves government expenditures and taxes, and both are will be impacted in early January unless Congress and the president come to an agreement about how to change things. On January 1, the Bush tax cuts will expire so rates will return to those that prevailed in 2000. The lowest rate will increase from 10 to 15 percent, the next from 15 to 25 percent, and the remaining by smaller amounts--mostly by 3 percentage points. Other tax changes would also take place such as increased in capital gains and taxes on dividends, and a return to the criteria for the Alternative Minimum Tax that prevailed in 2000. According to the non-partisan Tax Foundation, the increased taxes collected would be $514 billion.
Government spending will also be cut. The law has federal government expenditures falling by $110 billion, divided evenly between defense spending and discretionary non-defense spending, i.e., exclusing Social Security, Medicare, federal pensions and federal salaries. So, both the tax increases and the cuts in government spending are considered contractionary policies, which most economists would consider unwise in a weak economy.
A simplistic way of looking at the effects would be to take the components of GDP and see the impact. In the third quarter of 2012, we had: C = $11,149.4 billion, I = $2080.4 billion, G = $3090.1 billion, and net exports = -$522.9 billion. This gives a GDP of $15,797.4 billion. THe fall in G of $110 billioin reduces government spending to $2908.1 billion, which would lower GDP by 0.7%. Assuming the tax changes lead to reductions in consumption spending, we would have C=$10,35.8 and end up with a reduction of GDP of 3.9%. If spread over a couple of quarters, we would have a recession.
Some argue that the "cliff" is really a "slope" because the changes will occur slowly over the year. People will see lower take-home pay in each paycheck. So, if the new Congress acts, the effects would be minimal. But since the major players politically are the same as we now have, it is difficult to see how a new Congress will so different from the status quo.
There are also some who argue we should go over the cliff. For example, Howard Dean, the former chair of the Democratic National Committee argues "progressives" should want to go over the cliff because it will generate greater tax revenue to fund programs with. The tax increases are about five times more than the spending cuts.
Two other issues worth considering. First, most estimates of government multipliers from before the recent recession were that the multiplier on tax changes was greater than the multiplier on expenditure changes, and permanent changes have much bigger impacts than temporary changes. If so, then the contractionary effects of the tax increases will be much greater than the effects of the spending cuts. Second, tax changes also affect incentives, which would also be a drag on the economy.
On the other hand, if one is not a Keynesian, should one think the effects in the long run may actually be positive?