Maximizing GDP Growth with Minimal Budgetary Cost in the Face of the Fiscal Slope/Cliff

We can maintain momentum, while moving toward budget sustainability, by allowing the Bush tax rate cuts for incomes above $250,000 to expire

Last Thursday, CBO released Economic Effects of Policies Contributing to Fiscal Tightening in 2013. The bottom line is summarized in Figure 1.

Figure 1 from CBO (2012).Note that if one extends “most expiring tax provision, except for the lower tax tates on income above certain thresholds, and Index the AMT for Inflation”, then output will be 1.3 ppts above baseline (which obtains under current law) by end 2013, compared to 2.9 ppts if all expiring provisions were extended, and sequester eliminated (call that the alternative fiscal scenario plus the reduction in the employer portion of payroll tax reduction, plus extended UI; I’ll call this alternative-plus). If in contrast the tax cuts above certain thresholds were also extended, then output will be 1.4 ppts above. In other words, it barely makes a difference to growth whether the tax rates on high incomes are extended, although it makes a big difference to revenue ($56 billion of the total $192 billion associated with the Bush tax cuts). Hence, it is a no-brainer to eliminate the tax cut for high income households.

Another way of making comparisons is to note that if only the tax provisions are extended, then output is 1.5 ppts lower than alternative-plus; if only the low income tax provisions are extended, the output is 1.6 ppts lower – using the midpoints of the ranges of multipliers.

It is arguable that with interest rates at zero, the multipliers are at the higher end of the ranges given. Using the maximum values, output would be2. 5 ppts lower under than the alternative-plus scenario if all tax cuts are extended, and 2.7 ppts lower if only the tax cuts for lower incomes are extended.

Figure 2 below shows the trajectory of GDP under current law (red line), and if some tax provisions are extended.

Figure 2: Log GDP (blue), log CBO forecast GDP under current law, from August 2012 (red), and GDP if all Bush tax cuts extended plus AMT fix (green square), and if Bush tax cuts are extended only below threshold (purple inverted triangle). Corresponding open square and inverted triangle use top of the range of multipliers. NBER defined recession dates shaded gray. Source: BEA, 2012Q3 advance release, 2012Q3 value adjusted to 3% growth, SAAR; CBO, Budget and Economic Outlook: An Update (August 2012)CBO, Economic Effects of Policies Contributing to Fiscal Tightening in 2013 (November 2012), NBER, and author’s calculations.Note that other (private sector) analysts concur that the effects of letting the upper income tax cuts lapse are minor (i.e., the “bang for the buck” of high income tax rate reductions is small); see the estimates from Goldman Sachs in Figure 1 in this post.

In addition, retaining the payroll tax cuts and AMT patch, as Jim proposes, would also be a cost-effective means of sustaining growth.

This post was originally published at Econbrowser and is reproduced here with permission.