It's a Slope Not a Cliff

That's how my CBPP colleague Chad Stone describes the fiscal contraction set for the end of this year when tax cuts expire and automatic spending cuts kick in.

It's an important and salutary distinction. Go over a cliff, and you're pretty much toast, like at the end of Thelma and Louise. Start down a slope and if you turn around soon enough, you don't have to go down too far.

What's the distinction? Why the semantics? Because if policy makers fail to distinguish between cliff and slope effects, they might be drawn into extensions of the expiring policies that do more long-term economic harm than we'd get from a short trip down the slope. And the most notable such expiration is the high-end Bush tax cuts. That should sunset on schedule at the end of this year.

For the health of the economy in 2013-14, the important issue with respect to the tax cuts is to ensure that tax cuts for low- and moderate-income households do not expire; the fate of the Bush tax cuts for the top 2 to 3 percent of taxpayers should be of little economic consequence in 2013 and 2014. Moreover, if only the tax cuts for lower- and middle-income households are extended, high-income taxpayers will still benefit from the reduced tax rates on the full portion of their income that falls in the lower tax brackets. CBO's analysis indicates that a cost-effective way to continue using the tax cuts to shore up the weak economy would be to extend the middle-class tax cuts for a year or two, allow the upper-income tax cuts to expire, and extend the tax-credit expansions targeted on low- and moderate-income households. Such an approach would provide the most "bang-for-the-buck" in terms of supporting the economic recovery in 2013-14 without seriously compromising long-term fiscal sustainability.

None of this is meant to be cavalier. As I've written elsewhere and stressed to anyone who will listen, the last thing this economy needs right now is another self-inflicted wound. It would be better to resolve this tomorrow, but that's extremely unlikely. That means that if Democrats and the White House hold out for high-end sunset, we most likely start down the slope in January of next year.

I worry -- a lot -- about that outcome. The expirations of the payroll holiday and the middle-class tax cuts mean that paychecks will fall noticeably right away (through greater withholding in the latter case). And the automatic cuts are already creating uncertainty about the near future among government contractors. And one can be forgiven for imagining that the politics of compromise are not in a hugely better place in 2013 than they are today. A few weeks, maybe a month down the slope will hurt, but it's unlikely to be seriously damaging to growth. A few months... that's different.

But that doesn't mean we should just give up on better policy outcomes. Too often in these situations, someone yells "fire" (i.e., recession!) and policy makers scramble to kludge together something, most often under the heading of kicking-can-down-road.

And, in fact, a partial can-kick makes sense here. Most of this stuff should be extended until the economy enters the virtuous cycle I describe here. But a full-can-kick doesn't. And given the fact of our revenue needs and the small multiplier on the high-end tax cuts, their time has come.

This post originally appeared at Jared Bernstein's On The Economy blog.