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Policy Brief 12-15

Restoring Fiscal Equilibrium in the United States

by William R. Cline, Peterson Institute for International Economics

June 2012

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The United States faces a “fiscal cliff” at the end of calendar year 2012, when the two major tax cuts from the Bush era and some other tax provisions will expire and in the absence of action scheduled reductions in spending will begin. The subsequent increase in taxes and reduction in spending would dramatically tighten the federal budget deficit at a time when unemployment remains high. On an annual basis the total impact of the fiscal cliff amounts to a reduction in the federal budget deficit of about $800 billion on a direct basis (about 5 percent of GDP). After taking account of revenue losses and extra social spending resulting from induced slowdown in the economy, the Congressional Budget Office places the net fiscal impact at $560 billion for the first nine months of 2013, implying $745 billion or 4.5 percent of GDP for calendar year 2013. An aging population and rising health care costs continue to boost federal spending under current policies, and it is critical that the United States put the budget on a sustainable path, which will require significant changes in spending  and tax policies. It is therefore difficult to escape the conclusion that it is a good thing that the United States faces a fiscal cliff. The expiration of the Bush era tax cuts at the end of 2012 provides a unique opportunity to raise tax rates and/or eliminate tax deductions so that the United States can restore federal revenue to at least 18 percent of GDP and probably more in order to meet growing fiscal needs associated with an aging population. The political pain of higher tax rates should concentrate political minds on the associated task of finding more ways of cutting spending and limiting increases in entitlement spending. It will nonetheless be important to phase in the fiscal adjustment gradually, for example, over the four years of the next presidential term, in order to moderate the output loss that would otherwise occur under current conditions of high unemployment combined with interest rates near zero. Moreover, Cline says the needed structural fiscal adjustment amounts to 3 percent of GDP and the component of overkill included in the fiscal cliff’s 5 percent of GDP adjustment should be avoided.


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