Tuesday, 20 November 2012

Do we need to fear the fiscal cliff? II.


As promised in our post yesterday, today we will examine the arguments in favour of and against going over the fiscal cliff. In order to do so, we will construct them around the four questions already mentioned: does the cessation of tax cuts brings down debt? Does it hurt the economy? Do debts hurt the economy? And which one of the two is more important?


The four questions


The following are the four questions we have identified yesterday as key issues in any discussion regarding the fiscal cliff.


A) Will the abolition of tax cuts bring down federal debt?
B) Would doing so hurt the economy? How?
C)  Are the current debt levels destructive for the US economy?
D) If C) and B) is true, which one is better - a debt relief in exchange for a temporarily hurt economy, or sustaining the status quo, and watching debt levels increase?

Those who wish to go over the fiscal cliff in the name of federal budget balance (from now on: fiscal cliff proponents) will have to show that A) is true, C) is true, and if B) is true then it's setbacks are less important than the setbacks of C); or simply that B) is false.
Those who wish to retain the current tax laws (from now on: fiscal cliff opponents) will have to show that B) is true, C) is false, or it's setbacks are less substantial than the setbacks of B). Note, that I have not required to prove A) false;  I did so because as it will be seen below, A) can easily be shown to be true, and was more of a formal distinction.

Tax rises and debt decreases


Supporters of the fiscal cliff firstly need to prove A). In order to do so, they only have to show that the tax cut abolition will reduce government deficit; that would on it's own gradually reduce debt growth, and should the deficit disappear, debt itself. 
Tax cuts abolished, in other words, mean taxes raised (as we will refer to them from now on); raised taxes mean more revenue for the government, and hence less deficit. The only way this would be untrue if people started engaging in mass tax evasion AFTER the de facto tax raises. However, since the tax cuts decreased government revenues at the time of their introduction (see link), it is hard to argue that a return to the pre-2002 situation would cause a further decrease in revenue. This proves A.

Do tax rises hurt the economy?


Source: Wikimedia
The second question B is the most controversial one; would the tax rise hurt the USA economy as a whole, and how much?
The answer seems to be yes; along numerous examples, the  infographic to the right, based on Congressional Budget Office data, predicts that GDP growth would be negative in 2013 (-0.5%) should the cut abolition occur, as opposed to the 1.7% predicted growth rate with cuts still in effect. (Click to enlarge; this proves B.)
To counter-balance a 0.5% shrinking in growth, the economy would need to grow with an extra 2.2% in 2014.
How is that number reached?
Take the 2012 situation as 100%.  A 0.5% shrinking would reduce that to 99.5%. In order for 2014 levels to reach what it could have reached without cut cessation (101.7%), it needs to grow by 101.7/99.5=1.022
 factor; in other words, 2.2%.
That might seem like a lot in relative terms;  but remember that on the other hand, the fiscal cliff would also mean a large reduction of federal debt.  And there is a reason while America's contemporary mayhem is sometimes dubbed as a debt crisis;  higher debt ratios curb foreign investment (not just because it becomes more scary to invest in the USA; but also because investors will start buying government bonds instead of directing capital straight to companies), this consequently reduces private capital. According to this IMF working paper:
"...on average a 10 percentage point increase in the initial debt-to-GDP
ratio is associated with a slowdown in annual real per capita GDP growth of around
0.2 percentage points per year." (This proves C.)

Conclusion


If A,B, and C are all true, then how do we weigh between them? To ease calculation, let's concentrate on the year 2022 of the infographic prediction; the difference between debt levels by this point would be 32%. According to the paper above, that alone means a 0.6% GDP decrease, bigger than the one-time 0.5% in 2013; not to mention every other year's debt-for-growth cost between 2014 and 2022. This proves that B) is less powerful than C); hence, the fiscal cliff should be passed.

Naturally, there are problems with this argument as well; namely, the reliability of the IMF paper and the US Budget Office research. What this post tried to prove however was that conclusions about complex macroeconomic phenomena can (and should) be reached by relying principally on logic. Feel free to share your contradictions, opinions - we'll be happy to reply.

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