With their Keynesian analysis, the Congressional Budget Office and others have exaggerated the effects of the “fiscal cliff” on the labor market and the economy.
Come January, current law provides for significant cuts in federal spending and for tax increases – and thereby significant federal budget-deficit reduction. These provisions have been collectively described as the “fiscal cliff,” which emerged when Democratic and Republican leaders could not agree on plans on spending and taxes.
The Congressional Budget Office has warned that the fiscal cliff will cause a double-dip recession, but its analysis for 2013 is based on the Keynesian proposition that anything that shrinks the federal budget deficit shrinks the economy, and the more the deficit is reduced the more the economy is reduced.
In many circumstances, the Keynesian proposition reaches the wrong conclusions about economic activity, because deficits do not necessarily expand the economy or prevent it from shrinking. For example, reducing the deficit by cutting unemployment insurance – it’s one of the programs that would be cut in January – would shrink the economy in the C.B.O.’s view.
But in reality, cutting unemployment insurance would increase employment, as it would end payments for people who fail to find work and would reduce the cushion provided after layoffs.
Helping people who are out of work may be intrinsically valuable because it’s the right thing to do, but the Congressional Budget Office is incorrect to conclude that it also grows the economy or prevents it from shrinking. Paying people for not working is no way to put them to work.
The Keynesian proposition about budget deficits ignores incentives of all kinds, so its incorrect conclusions about the fiscal cliff are not limited to unemployment insurance. Another example: the fiscal cliff would put millions of Americans on the alternative minimum tax, which Keynesian analysis said would shrink the economy solely because it collected more revenue.
Yet economists who have studied the alternative minimum tax have found that its effects on incentives to work and produce are essentially neutral, compared with the ordinary federal personal income tax.
(The Congressional Budget Office does not use pure Keynesian analysis for its long-term projections, which include labor-supply incentive effects of tax rates, but apparently has decided that incentives’ effects can be safely neglected in the short term.)
None of this implies that the fiscal cliff will expand the economy, because some of its provisions will increase the penalties for working and producing.
The fiscal cliff would cut Medicare payments to doctors by 2 percent, which reduces doctors’ reward for treating Medicare patients. This may cause doctors to work less (or to work more for non-Medicare patients). The fiscal cliff would end the “Bush tax cuts” provisions, some of which have been enhancing the incentive to work (but beware – not all laws labeled “tax cuts” enhance incentives).
Perhaps the incentive-reducing provisions of the fiscal cliff outweigh its incentive-enhancing provisions, in which case the Congressional Budget Office has arrived at approximately the right answer for the wrong reasons.
But even in that lucky case, the C.B.O.’s quantitative estimates of the fiscal cliff’s economic effects are not reliable until they fully incorporate economic incentives.