Pundits and politicians are warning that the U.S. economy could go over a "fiscal cliff" on Jan. 1, when, under current law, we will face a double whammy of large spending cuts and significant tax increases. This, they warn, could trigger another recession.
Under the Budget Control Act of 2011, the changes are slated to take place automatically.
This is the law, you will recall, that established the so-called deficit-reduction supercommittee, whose job it was to reduce the deficit by $1.2 trillion over 10 years. As an incentive to the committee to get the job done, the law contained a default mechanism: If the committee failed to reach agreement, automatic spending cuts, known as "sequestrations," would go into effect, and there would be an automatic return to earlier tax rates (in short, a major increase in rates).
While Americans are right to be concerned about this looming fiscal cliff, the problem with the story is that it fails to recognize reality. The reality is that the big spenders in Washington pushed the U.S. economy over a fiscal cliff years ago.
During the past three years, we've had trillion-dollar-plus annual budget deficits. In the past 12 years, our national debt has grown from less than $6 trillion to more than $16 trillion. The federal government's share of the economy -- that is, government spending as a percentage of gross domestic product (GDP) -- has grown from less than 20 percent to more than 25 percent. Forty cents of every dollar the government spends is borrowed. As draconian as the pending spending cuts and tax increases may seem, they only would cut the annual deficit in half -- at best. This means we still would be adding huge sums to the federal debt.
This also means it will be difficult to grow ourselves out of the problem. As the European debt crisis has made abundantly clear, excessive public debt reduces economic growth. Unless we can solve this problem, the United States under its new economy is going to perform more like old Europe than the old United States.
If we do not reverse course and make some fundamental changes, our government and our public debt will only get bigger.
Entitlement programs, such as Medicare, Medicaid and Social Security, will grow rapidly as baby boomers retire.
Our newest entitlement program, the Affordable Care Act (Obamacare), will provide major new subsidies to workers for purchasing health insurance. The Kaiser Family Foundation estimates, for example, that a family of four whose head of household is age 50 and whose household income is $80,000 will receive $9,258 in annual subsidies to buy health insurance. I'm not sure which alternative universe the White House is living in when it claims that the Affordable Care Act will add little if anything to the budget deficit. But with subsidies this large, expect the actual costs to be in the hundreds of billions annually.
Interest rates on our government debt are at unsustainably low levels, held down by a combination of the flight of capital from Europe, our slow economy and the Federal Reserve's quantitative easing policies. Despite this, interest payments on the debt still cost about $230 billion annually. Those interest payments will cost the "average Joe," who is 42 years old and makes $26,000 per year (the average age and wage of working Americans in 2011) more than $43,000 in future federal taxes, according to MyGovCost.org calculations.
When interest rates rise, as they surely will, servicing the debt will cost even more, putting more pressure on budget makers. If members of Congress do in the future as they've done in the past, they'll borrow -- increasing the amount of debt even more.
Slow growth and high unemployment rates are systemic problems arising from the size of government and the burden of debt. These problems are not easily remedied. Creating more debt now to stimulate the economy translates into even slower growth later.
Despite the dire warnings of impending doom, it just might be that the Budget Control Act's fiscal cliff will better serve the long-run interests of the United States than a short-term congressional compromise that fails to get to the core of the problem. It's not a perfect solution, and it doesn't solve the long-term budget problem, but it's a start.
Burton A. Abrams is a research fellow with the Independent Institute and professor of economics at the University of Delaware.