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Tax VOX

A recipe for recession

What will happen to the economy if Washington can't overcome its political gridlock?

By Guest blogger / September 2, 2011

This CBO chart shows the projected GDP deficit and surplus through the next decade. If fiscal laws remain as is, the deficit will shrink, but the national debt will continue to increase.

Congressional Budget Office

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Given Washington’s endless partisan nastiness—and thanks to some updated estimates by the Congressional Budget Office–it seems like a good time to revisit an old idea: What would happen if Congress and the White House just closed up shop for a couple of years and let fiscal policy run on autopilot?

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The question is not so far-fetched, since it describes exactly what could happen if Congress’ budget super committee fails and Washington is still locked in political gridlock at the end of next year. The answer? We’d dramatically reduce the projected short- and medium-term deficit and probably throw the economy back into recession.

Take a look at the CBO chart above. It may look familiar since my Tax Policy Center colleague Bob Williams used it just last week to describe the consequences of extending the 2001/2003/2010 tax cuts. He wanted you to focus on the dark blue area of the chart. But this time, think about the light blue part at the top.

In CBO-speak, this is the world of current law. In English, it means all of the Bush/Obama tax cuts expire at the end of next year, the Alternative Minimum Tax would hit about 20 million households, and Medicare instantly cuts payments to physicians by one-third. In addition, since August’s debt limit agreement would take effect as designed, discretionary spending would be cut across-the-board by 5 percent—with half of those reductions coming from the Pentagon.

Allowing taxes to rise and slashing discretionary spending would sharply reduce the deficit, all right. It would plummet from 8.5 percent of Gross Domestic Product this year to 3.2 percent in 2013 and 1.6 percent in 2014. The national debt would still grow, of course, but the increase would be manageable. It all sounds so simple.

There are just two flaws in this strategy. Unfortunately, they are pretty big ones.

The first is that without getting medical costs under control, these draconian steps still won’t fix the nation’s long-run fiscal problem.

The second–more immediate—problem is that slamming on the fiscal breaks would likely wreck what may be a still-weak economy. Compared to this year, spending in 2013 would effectively be frozen, while taxes are increased by $750 billion.

CBO projects such a sharp dose of austerity would slash economic growth by between 1.5 and 3.5 percentage points in 2013. With most economists projecting a 2013 expansion of about 3.5, this could cut growth by between one-third and, well, 100 percent. Keep in mind that with interest rates at close to zero, the Federal Reserve couldn’t do much to help. And, btw, while CBO doesn’t try to estimate what a new recession would mean for the deficit, it wouldn’t be pretty.

I am in no way suggesting that bringing spending and revenues back into line is not a good idea. It is, and it would have long-run economic benefits. But policymakers have to put away the meat axe and get smart.

Instead of arguing over whether the Bush/Obama tax cuts should expire at the end of 2012, lawmakers should reframe the debate around how to structure the revenue code so it makes sense. They need to stop pretending they can fix the deficit through discretionary spending alone and get serious about making significant but gradual changes in health care costs. And finally, they must design a fiscal plan than includes both short-term stimulus and real long-term deficit reduction.

Optimists say the very risk of recession caused by fiscal gridlock may be sufficient to convince Democrats and Republicans to reach a sensible deal. Maybe, but given the latest petty squabble over when the president should address Congress, that’s hard to imagine. All I know is that if they don’t get serious, we could very well be headed for Recession II.

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