Indiana University Experts Comment on 'Fiscal Cliff'

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President Barack Obama and Republican congressional leaders have been deadlocked over the "fiscal cliff," the tax increases and spending cuts that will take place Jan. 1 unless elected officials take action to avert them. The combination could have a dramatic impact on the economy, with the Congressional Budget Office forecasting that unemployment could increase to 9 percent. Indiana University experts offer their perspectives.

Catherine Bonser-Neal, associate professor of finance at the Kelley School of Business Indianapolis, said the need to reduce the federal deficit is clear, but how it is accomplished could have long- and short-term growth implications.

"The balancing act being examined by members of Congress is how to minimize the short-term economic-growth impacts of a cut in the budget deficit against the longer-term need to reduce the level of U.S. debt as a share of the economy," Bonser-Neal said. "However, history and economic research suggest that a preference to avoid short-term pain should not be put ahead of the need to address the country's long-term debt problem.

"Absent reductions in the fiscal deficit, the U.S. debt level will continue to grow as a share of our economy, with the result being that an increasing share of U.S. income created will need to be directed toward servicing and repaying the federal debt, instead of being directed toward new investment opportunities.

"Not only will this reduce U.S. economic growth prospects, but research also indicates that the ability of a country to service and also repay its debt becomes at risk when that country's debt-to-GDP burden exceeds a certain level. Absent changes in the level of the deficit, the U.S. will be on a path to reach and in time surpass this level."

Just as economists debate the impact of short-term stimulus and expansionary fiscal policy that creates a budget deficit, they also disagree about the size of the short-term negative effect of a reduction in the budget deficit, she noted.

"The answer is not a simple one and ultimately depends on how consumers, investors and businesses respond to a change in tax rates and to the changes in government programs. However, whatever the short-term impact, policy must be made with long-term consequences in mind. In particular, revenue-raising policies that reduce economic incentives to work, save and produce will only hinder economic growth and so could compound the difficulty of reducing the nation's debt-to-GDP burden.

"Furthermore, short-term cuts in government spending that do not address the longer-term spending trajectory of entitlement spending growth will mean the U.S. deficit will continue to grow."

The financial crisis and recession have pushed uncertainty about economic policy to historic heights, and the fiscal cliff ratchets it further, says Eric Leeper, Rudy Professor of Economics in the College of Arts and Sciences at IU Bloomington. And while economists don't have good quantitative estimates of how uncertainty affects the economy, basic reasoning tells us it makes decision-makers reluctant to undertake new projects, including hiring new employees, launching investments and expanding production.

"Yet economic calculations play a distressingly minor role in the on-going debate about fiscal policy," Leeper said. "If a political party determines there is political advantage in falling off the cliff, or in holding the country hostage by refusing to raise the debt ceiling, then that's the strategy it pursues."

He said it's "unfathomable" that, at a time when the U.S. economy continues to struggle, elected officials are willing to risk recovery to score political points. And it's equally incomprehensible that politicians minimize the potential economic disruption they're causing, as when some said during last year's debt-ceiling debate that it was "no big deal" for the U.S. to renege on its obligations.

"Perhaps most disturbing about the cliff fiasco is what it portends for how our officials will cope with the fiscal abyss that awaits us," Leeper said. As the population continues to age, Social Security and Medicare consume more of the economy. Any real solution requires rewriting the social compact Americans now have with their government. And social compacts cannot be rewritten in a partisan atmosphere.

"This long-term fiscal problem is not yet a crisis," Leeper said. "It need not be solved overnight, and it certainly should not be tackled through 11th-hour, closed-door negotiations. Instead, alternative solutions should be proposed and their economic consequences studied before any bills are written in Congress. We have the time to make good policy choices -- ones that make sense for the economy as a whole. What we lack is the political will to make thoughtful and deliberative economic policies."

Jerry Conover, director of the Indiana Business Research Center in the Kelley School of Business, said the impact on Indiana's economy will depend on which path Congress and the White House take as they wrestle over the steering wheel of that vehicle rushing toward the fiscal cliff.

"The most likely scenario is that they postpone a real decision, temporarily extending the current tax cuts and federal spending levels to buy time to reach a more comprehensive solution. This kicking-the-can-down-the-road strategy exacerbates consumer and business uncertainty, however, likely leading to very weak growth while waiting for a real fix. If such a fix were found, the economy would start ramping up slowly in 2013," Conover said.

"On the other hand, many in Washington may feel that letting the nation go over the cliff is the safest path politically. It could provide a clean slate for making more meaningful changes to tax and spending policy," he said. "However, the significant rise in taxes and cuts in federal spending the cliff entails would push the nation into a recession lasting two to three quarters, and total growth for next year would likely be flat at best. This is not a welcome scenario for a nation trying to get to the end of a very long cycle of recession and recovery.

"Hoosiers would certainly feel the pain, some more than others, depending on their employment and income circumstances. Loss of the Bush tax cuts would take a big bite out of disposable income, and our unemployment rate would rise. Many Indiana firms sell to businesses in other states, and their sales would likely take a hit as the national economy shrinks," Conover said.

"On the other hand, the federal spending cuts that sequestration requires would not hit Indiana as hard as many states because the rate of federal spending in our state is well below the national average," Conover said. "Some of Indiana's biggest employers, however, such as our research universities and defense contractors, would likely feel sharp pain from reduction in the federal grants and contracts on which they rely. And defense facilities such as Crane may also be hard hit, which would be a major drag on the regional economy."

While the stakes are especially dramatic this year, the president and Congress have had considerable difficulty agreeing on a federal budget for over a decade, notes Leslie Lenkowsky, professor in the IU School of Public and Environmental Affairs. Yet many observers fear the cost of failing to agree on taxes and spending by the end of this year could be especially high.

"Fresh off his re-election victory, President Obama can claim support for raising taxes on the wealthy, a step many Republicans will oppose," Lenkowsky said. "However, he is now a lame-duck president, and how much political leverage he has -- and how concerned he is about his legacy, if another recession were to occur -- remain to be seen."

Republicans, on the other hand, are still debating who is to blame for their party's inability to capture the White House, Lenkowsky said. That may give the speaker of the House of Representatives, John Boehner, and other GOP leaders in Congress -- including Paul Ryan, now a front-runner for the party's 2016 presidential nomination -- more running room than they had before the fall elections.

If imagining political reasons for a deal -- and possible fiscal compromises -- is not hard, the recent history of federal budget disputes offers little reason for optimism.

"However, the consequence of inaction may not be as dire as the 'fiscal cliff' image suggests," Lenkowsky said. "The spending and tax changes will be felt slowly, not all at once. Federal agencies will have time to adjust their activities -- and, after 2013, their budgets are actually slated to grow, though not as rapidly as in recent years. Taxpayers will notice their paychecks going down gradually, but tax rates will rise only to 2001 levels. Congress will also have time to address any problems that may arise piecemeal, its typical way of legislating."

How the "real economy" -- investors, employers and others whose decisions affect growth -- will react to such inaction is the big question, Lenkowsky said. "But if the president and Congress are unable to produce a more comprehensive solution," he said, "smaller steps, accompanied by some modest belt-tightening, could prove reassuring."

Eric Schansberg, professor of economics at IU Southeast, says the U.S. faces not one economic precipice but two: a fiscal cliff and a debt cliff. And while the fiscal cliff is getting most of the attention right now, the other can't be ignored.

"There are three issues at hand," Schansberg said. "First, the underlying problems are our massive federal budget deficits and rapidly growing budget debt. Second, the potential solutions are also problematic. Actual reductions in government spending and big increases in tax rates would make it even more difficult for the economy to grow.

"Third, all of this contributes to what economists call 'regime uncertainty.' Nobody knows what Congress and President Obama will do -- from whether they'll address the problem to the particular solutions they'll embrace."

Schansberg argues that increasing taxes on the wealthy, preferably by closing loopholes, might be good politics for Republicans, even if it's bad economics.

"I'm not a fan of higher taxes," he said. "But if we're going to increase taxes, the rich are an attractive target: a small minority who can be easily tagged in a democracy. It wouldn't raise much money, and it would probably hurt the economy more than other policy choices. But the GOP would show a willingness to compromise and avoid a probable black eye, given the public's policy preferences.

"Most important, it would remove a huge distraction from the policy debate. Then we could focus on the critical choice: big spending cuts vs. big middle-income tax increases to close the budget chasm caused by our elected officials."

The "fiscal cliff" can best be understood as "involuntary fiscal austerity," says John Mikesell, Chancellor's Professor in the School of Public and Environmental Affairs at IU Bloomington and an expert on government finance. And while fiscal austerity and reducing the federal deficit through spending cuts and tax increases may be a laudable goal, this isn't the way or the time to do it.

"Unfortunately, that reduction in deficit -- amounting to about 4.5 percent of gross domestic product -- will be occurring while the economy remains fragile after the Great Recession, and there is a significant probability that this deficit reduction will throw the economy back into recession," Mikesell said.

"If Congress and the president cannot agree on new laws to replace those in place, the big deficit reduction will start automatically. While controlling the federal deficit is an important eventual goal for economic sustainability, a drastic shock as the economy is struggling toward recovery from recession is not likely to be the best time to start the constraint."

The U.S. faces a potential economic crisis that requires a political solution. Yet not only are Democrats and Republicans unable to agree, but "both parties use rhetoric that is unsubstantiated from an empirical standpoint," says Todd B. Walker, assistant professor of economics in the IU Bloomington College of Arts and Sciences.

Republicans say increasing income taxes on individuals making over $250,000 per year will kill job creation. They argue that the increase would largely fall on small business owners and that small businesses are the lifeblood of the economy, creating the most jobs during times of economic growth.

"Both of these claims are false," Walker said. "A recent report by the Joint Committee on Taxation found that only 3 percent of small businesses would be impacted by the tax increase. A 2011 study by the U.S. Treasury found that only one-fifth of small businesses had any employees. Finally, a recent academic paper argued that young firms, not small firms, are the job creators."

But Democrats, with a few exceptions, seem to suggest that substantial entitlement reform is not needed, even though Medicare will be the primary driver of government spending over the next several decades.

"The current fiscal dilemma is small potatoes when compared to the problems that may materialize if entitlement reform is not taken seriously," Walker said. "If current law is unchanged, the Congressional Budget Office has projected that Medicare, Medicaid and Social Security will increase from 9 percent of GDP today to around 18 percent by 2040, an unsustainable number."

Walker said much government spending has been financed by foreign investors, but demand for U.S. government debt remains strong and interest rates remain low, primarily because U.S. debt is considered risk-free. But good reputations are difficult to acquire and easy to lose. Standard & Poor's first-ever downgrade of U.S. debt, at the time of the debt-ceiling debate, had everything to do with the current political quagmire.

"What the economy needs most now is political leadership," Walker said. "A failure of leadership could prove disastrous."

Kyle J. Anderson, clinical assistant professor of business economics at the Kelley School of Business Indianapolis, said an agreement must be reached in order to avert another recession.

"Failure to reach a deal will likely lead to recession in 2013. Higher taxes and less government spending will lead to lower consumer spending, and the unemployment rate will move higher rather than lower," Anderson said. "There is also concern that if we 'go over the cliff,' then Americans will lose confidence in the ability of the government to deal with our problems. A loss of consumer and investor confidence could make the recession severe and take us back to 2008."

Anderson said policy makers need to recognize the necessity of tax increases and spending cuts over the long term but should look to phase these in gradually so they don't cause significant damage to economic growth.

"The greatest threat to our long-term fiscal situation is our rapidly rising health care costs. Medicare costs will continue to rise due to an increasing number of retirees and the rate of cost increases in medical care," he said. "Unfortunately, there are no easy answers to addressing this problem, which means that government spending will continue to grow over the next decade."

Unfortunately, Anderson believes that Congress and the president will take another Band-Aid approach to the issues.

"Some sort of deal is likely to get done, but it may be more of a temporary fix rather than the tax and spending overhaul that most Americans would like to see," he said.

An important thing to understand about the "fiscal cliff" is that it is entirely the creation of recent legislation; there is nothing fundamental about it, says Steve Russell, professor of economics in the School of Liberal Arts at Indiana University-Purdue University Indianapolis.

"From the debate on the subject, you might get the idea that the federal government faces a fundamental budget crisis after the first of the year: that it may default on its debt, or run out of funds to finance its spending, or something of that sort," Russell said. "Nothing could be further from the truth. The government does have long-run budget problems, but we have plenty of time to face them, if we act wisely."

Russell notes that the fiscal cliff results partly from the Budget Control Act of 2011, which calls for deep cuts in expenditures after the end of the year; Republicans insisted on these cuts as a condition for increasing the debt ceiling. The rest of it is caused by the scheduled expiration of tax cuts, including the Bush tax cuts of 2001-03, which Democrats were not willing to make permanent. The combination of big federal spending cuts and large tax increases may result in a large, abrupt decrease in the demand for goods and services.

"This could push the economy back into a recession," Russell said. "It is a bigger concern because the economy has not yet fully recovered from the current recession. In a sensible world, the Republicans and Democrats would get together and agree to put off both the tax increases and the spending cuts for a year or two, and then phase them in gradually, over two or three years. But it is not a sensible world."Russell can be reached at shrusse@iupui.edu.

Timothy Slaper, research director of the Indiana Business Research Center in the Kelley School of Business, said the strength and rapidity of economic hits resulting from a stalemate on the "fiscal cliff" is still an open question.

"Based on the economic forecasts of how the 2009 stimulus would impact the economy, one can state with reasonable certainly that the current forecasts of how the fiscal cliff will affect the economy are also going to be off target," Slaper said. "It is extremely difficult to get the timing right with these models -- that is, when the hits will take their toll.

"The payroll tax holiday and income tax withholdings will hit immediately, with the first paychecks in January. The effects of businesses stopping their hiring and investments in plants, equipment and inventory will take a little longer to be realized. The cuts in federal spending -- the "sequestration" -- will also have some delay. Recall that it took several years for some of the stimulus money to make its way through the pipeline, and turning off the tap for the sequestered budgets won't be immediate," he added.

While the divot in disposable income and consumer spending, together with the loss of federal spending, would be enough to cause a brief recession in early 2013, the loss of business confidence in the political process and the attendant investment pull-back may do the greatest damage. Recall that consumer and business confidence suffered in the summer of 2011 because of the budgetary impasse.

Probably the best one could hope for, Slaper said, is that Congress and the president delay action for another year, with both sides agreeing to extend the entire package another year. Or the parties could agree to extend the middle-class tax cuts only -- a win for the president. In return for forgoing a debt-ceiling fight in 2013, there would be fundamental tax and entitlement reform -- a win for the Republicans.

"This wouldn't remove the fiscal cliff so much as making it more like a fiscal bunny hill, but with the advantage that both parties would signal to businesses, investors and our global partners that Washington can work. Business and consumer confidence would be restored, providing the economy a badly needed tail-breeze," Slaper said.