The CBO Estimates on the Fiscal Cliff Are Massively Underestimating Its Impact

The CBO just came out with a new report providing projections on what will happen if we go off the fiscal cliff.  On the one hand it is showing that we will go into recession next year, with GDP falling 0.3% and unemployment rising to 9.1%, but our deficit will shrink dramatically, going from over $1 trillion down to $641 billion.  Longer term, the CBO estimates that debt held by the public will be 58% of GDP in 2022 instead of 90% if we avert it.  Essentially the choice is a mild recession in 2013 and righting the fiscal ship or growing at a meager 1.7% next year and kicking the debt can down the road.  With such framing, you can easily convince yourself to just go over the cliff and deal with the short term consequences.  Unfortunately, the CBO estimates are complete fantasy with no basis in reality.

Taxes are set to go up by 3.4% of GDP next year, this is money that is going to be taken out of people's pockets and will just disappear.  It's not like the government will increase spending with that money, they will spend about the same amount regardless of whether the taxes come in or not.  That means there will be nothing to counterbalance the tax increase to cushion the blow to the economy.   So if 3.4% of GDP simply disappears, you would expect that GDP would contract by at least 1.7% next year, not the 0.3% that the CBO estimates.  But even that is underestimating how bad the recession will be next year as the tax multiplier is over 1.  Every dollar that a taxpayer spends is then often spent by the businesses and on and on.  Some believe that the tax multiplier could be 3, so if you use that figure, you would expect a negative impact totaling 10.2% of GDP, which would lead to us having a down 8.5% GDP year in 2013.  Another reason to expect a much worse than expected 2013 is that our economy is already slowing because of weakness in China and Europe.  There is a chance we would go into recession next year even without the fiscal cliff, so if you add the fiscal cliff to that and you get a severe economic contraction.  If our economy was going to have a down 1% year next year due to the global economic slowdown and then 3.4% of GDP vanishes, you suddenly have a down 4.4% year and that is with a tax multiplier of only 1!  We could be headed for economic disaster if we increase taxes by that amount when the economy is slowing at the same time.

Another issue I have with the CBO estimate is its long term projections for GDP.  They expect to have just a short 1 year recession with real GDP growing at 3.1% in 2014 and a whopping 4.8% in 2015.  They then expect no recessions at all through 2022, which is pretty remarkable considering we seem to be set to have our third recession in 12 years.  What this means is that the CBO's long term debt forecasts are completely bogus.  Our debt in 2022 is likely to be much larger than 58% of GDP as the debt will likely be larger (due to higher than expected deficit spending in recessions) and GDP is likely to be smaller (as we aren't likely to have the hypergrowth and recession-free period as the CBO forecasts suggest). 

I suspect the CBO just gave the politicians enough rope to hang the country with.