The entire discussion of the "fiscal cliff" has things a bit backward.  People talk of "going off" the fiscal cliff -- and the natural image is of the disaster that awaits one who tumbles from the edge of a precipice.  Instead, perhaps we should say "running into" the fiscal cliff -- the cliff being a force that stops a tumble.

The term "fiscal cliff" refers to the combination of two major policy changes due to go into effect in January 2013:

1. The sequester. Because the (not-so-)Super Committee succumbed to partisan paralysis and couldn't come up with anything better, the sequester will begin making automatic spending cuts across domestic discretionary (50 billion per year) and defense (50 billion per year) programs.
   
   
2. The Bush and Obama tax cuts expire. The Bush tax cuts increased the deduction for children, cut marginal tax rates, and cut dividend and capital gains tax rates.  The Obama tax cut reduced the amount workers pay for Social Security without reducing benefits.  In addition, a Medicare "doc fix," which increased reimbursements for hospitals, is due to expire.

Running into a cliff isn't fun.  It would raise nearly everyone's taxes.  It would cut spending on most of the programs everyone uses.  It would temporarily raise unemployment rates.  But the fiscal cliff would back us away from a true disaster scenario, and it would slow the growth of the government debt.

Moreover, the fiscal cliff is an enormous opportunity for House Republicans.  If they simply allow it to occur, they win big politically in the negotiations.  They will get credit for fiscal responsibility, while the Obama administration will get the blame for the tax increases and will lose the leeway to offer new giveaways to its constituencies

Unemployment Rate and the Fiscal Cliff

The news media are currently trumpeting the first paragraph of a November 8 report (Economic Effects of Policies Contributing to Fiscal Tightening in 2013) from the Congressional Budget Office (CBO) which claims that the fiscal cliff will raise the unemployment rate to 9.1% in the fourth quarter of 2013.  That paragraph states:

According to the Congressional Budget Office's projections, if all of that fiscal tightening occurs, real (inflation-adjusted) gross domestic product (GDP) will drop by 0.5 percent in 2013 (as measured by the change from the fourth quarter of 2012 to the fourth quarter of 2013)-reflecting a decline in the first half of the year and renewed growth at a modest pace later in the year. That contraction of the economy will cause employment to decline and the unemployment rate to rise to 9.1 percent in the fourth quarter of 2013.

However, our own economic analysis suggests that the CBO is exaggerating the unemployment danger.  When we did a statistical analysis of unemployment rates over recent years in all of the economies with GDPs of $100 billion or larger, we found that budget deficits don't much affect unemployment rates in trade-deficit countries.  That's because when budget deficits go up, the stimulus leaks out as higher trade deficits, and when budget deficits go down, they are accompanied by reduced trade deficits.

The CBO was unable to predict the unemployment rate that resulted from President Obama's $800-billion February 2009 recovery act.  In March 2009, it predicted that the Recovery Act would produce an unemployment rate of between 6.0% and 6.3% by the fourth quarter of 2012.  But the actual rate in October 2012 was 7.9%.  The CBO's models appear to overestimate the effect of budget surpluses and deficits upon unemployment rates.  It is using an inappropriate model of the economy.

The Precipice and the Fiscal Cliff

U.S. national debt is already reaching levels associated with slower growth, and current levels of borrowing pose a threat to long-term prosperity.  The media has been relatively quiet about the second paragraph of the CBO report -- that without fiscal responsibility, the U.S. economy faces imminent disaster.  The CBO wrote:

If the fiscal tightening was removed and the policies that are currently in effect were kept in place indefinitely, a continued surge in federal debt during the rest of this decade and beyond would raise the risk of a fiscal crisis (in which the government would lose the ability to borrow money at affordable interest rates) and would eventually reduce the nation's output and income below what would occur if the fiscal tightening was allowed to take place as currently set by law.

The actual scenario is even worse than the CBO makes out.  If the U.S. national debt continues to explode, then, eventually, when the Federal Reserve raises interest rates to prevent inflation, the rising interest rates will greatly increase the interest component of the federal budget.

From then on, either alternative would be a disaster: (1) the federal government could default, or (2) the Federal Reserve could take the brakes off inflation.  In either case, the dollar would collapse in the currency exchange markets, interest rates and import prices would go sky-high, and the U.S. standard of living would hit the bottom with a splat.

Don't Kick the Can Down the Road Again!

The federal election results are in, and the status quo won.  Republicans retained their House majority, Democrats the Senate and the presidency.  Markets quickly recognized that this status quo win is unfortunate, as evidenced by the large drops in worldwide stock markets immediately after the election.  This is the cast of characters that kicked the can down the road last time they negotiated, which has already produced one downgrade of the U.S. credit rating.

The election settled some things, including some of the ways the U.S. might have dealt with the fiscal cliff.  Clearly, there are not going to be Romney-Ryan-type spending cuts without tax increases.  That solution would be the best option, but it is no longer on the table.  Three categories of options remain.

1. Run into the fiscal cliff.  Allow all of the tax cuts to expire.  Allow all of the spending cuts to go into effect.
   
   
2. Balanced deal.  Republicans and Democrats hammer out a compromise which insures that total U.S. government debt would be no worse in 10 years than it would be if the country ran into the cliff.
   
   
3. Kick the can down the road.  Bypass the sequester and renew the expiring tax cuts in the hope that the budget deficits will go away if ignored.

The best outcome is clearly a balanced deal, especially one that improves the tax system in a way that helps to balance trade.  Balancing the huge U.S. trade deficit would provide a stimulus that would give and keep giving.  There are at least three alternatives that would raise revenue and move trade toward balance at the same time:

1. Scaled Tariff.  Our invention, the WTO-legal scaled tariff (a single-country variable tariff whose rate rises as the trade deficit increases and falls as trade becomes balanced), would increase U.S. exports and stimulate U.S. business investment.  It would also raise about $280 billion of revenue (half of the U.S. trade deficit).
   
   
2. Tax Interest Earned by Private Foreigners.  In 1984, Congress eliminated the 30% withholding tax on interest earned by non-resident private foreigners.  Doing so caused the U.S. trade deficit to take off.  In our 2008 book, we estimated that restoring that tax would raise about $60 billion in revenue.
   
   
3. Tax Interest and Dividends Earned by Foreign Governments.  When foreign governments buy American stocks and bonds as a byproduct of their currency manipulations, they are exempted from paying U.S. tax on interest and dividends earned.  In our 2008 book, we estimated that a 30% withholding tax would generate about $45 billion in tax revenue.

If the House Republicans kick the can down the road in order to avoid the fiscal cliff, they will be helping Obama keep his voters off the income tax rolls.  They will be continuing the era of spending without taxing.  They will be moving the U.S. economy toward financial difficulty and even disaster.  Moreover, they will prove, yet again, that they have no intention of practicing the fiscal responsibility that they allege they are seeking.

The authors maintain a blog at www.idealtaxes.com and co-authored the 2008 book Trading Away Our Future.  Dr. Howard Richman teaches economics online.  Dr. Jesse Richman is associate professor of political science at Old Dominion University.  Dr. Raymond Richman received his economics doctorate at the U. of Chicago from Milton Friedman.