Table

of Contents
Fiscal Cli FAQs................................................................................................................. 3 Elements of the Fiscal Cli: Taxes....................................................................................... 4 Elements of the Fiscal Cli: Spending................................................................................. 5 The Economic Eects of the Fiscal Cli............................................................................... 6 Fiscal Cli Scorecard........................................................................................................... 13 The Taxa,on of Small Business: Pass-Through En,,es....................................................... 14 The Economic Impact of the Medical Device Excise Tax...................................................... 20 Na,onal Review Online: The Fiscal Cli.............................................................................. 25 Fiscal Times: Three Fiscal Flashpoints that Can Cause a Recession...................................... 27 Holtz-Eakin Discusses Fiscal Cli on Fox News On the Record with Greta Van Susteren..... 28 An Economic Guide to Cli-Diving.......................................................................................29 About the American Ac,on Forum..................................................................................... 32

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Fiscal Cli FAQs

What is the scal cli? The scal cli is a nearly $600 billion combina5on of tax hikes and indiscriminant spending cuts set to take eect on January 2, 2013. The cli is twice the size of GDP growth this year alone. The term was coined by Fed Chairman Ben Bernanke in February of 2012. The scal cli is comprised of seven legisla5ve components: The expira5on of the 2001/2003 tax laws. The expira5on of the Alterna5ve Minimum Tax. The expira5on of the payroll tax holiday. The introduc5on of new taxes in the Aordable Care Act, including the Medical Device Excise Tax and the 3.8 percent tax on people earning $250,000 or greater. The trigger of sequester spending cuts, defense and non-defense. The expira5on of the current rate for Medicare physician reimbursements (SGR). The expira5on of the current Unemployment Insurance policies.

The scal cli is not the debt ceiling nor is it necessarily the avenue for tax reform or en5tlement reform. The exis5ng components of the scal cli are large as is. What will happen if Congress fails to avert the scal cli? The Congressional Budget Oce, independent economists and the business community have warned that going over the scal cli will cause a recession and could drive unemployment up to at least 9 percent. Tax rates will increase for all families and many businesses, while harmful spending cuts will hit government programs -- both defense and non-defense, threatening the security of our economy and our country. AAF calcula5ons -- using the Administra5on's own math -- found that going over the scal cli will cause job losses between 2.8 and 10 million, bringing unemployment above ten percent, and sparking a 6 percentage point drop in GDP. Furthermore, our calcula5ons found that an increase in the top eec5ve individual tax rate from 35 percent to 42 percent would lower a small business likelihood of adding jobs by 18 percent. Ra5ngs agencies have also warned of another debt downgrade if Congress fails to avert the scal cli. Going over the cli will not only cause great economic distress in the United States, but the eects will likely be felt around the globe. Is the scal cli already hur;ng the economy? Reports indicate that businesses are already preparing for the scal cli. Hiring, growth, and investment has slowed as businesses look at the policies scheduled to become law on January 2, 2013. Can the eects of the scal cli be delayed? No. The scal cli is already being felt. Geeng to 2013 without a solu5on will cause a recession. If the United States goes back into recession, it will make solving the larger debt crisis even more dicult.

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Elements of the Fiscal Cli

Fiscal Cli Taxes
EGTRAA (2001) and JGTRAA (2003) Tax Laws The Bush Tax Cuts The 2001 and 2003 tax laws were extended to the end of 2012 in 2010. Among the many provisions, they lowered marginal tax rates across the board, created the 10 percent tax bracket, eliminated the marriage penalty, expanded the EITC, reduced the maximum taxes on dividends and capital gains to 15 percent, and phased-down to elimina5on the estate tax. If not extended (and the AMT see below not patched), every taxpayer would face higher taxes totaling $225 billion in 2013 and $4.5 trillion over 2013-2022. Using the same analysis as employed by the White House, this would translate to 2 percent lower GDP and over 1 million fewer jobs. The Alterna,ve Minimum Tax

The Alterna5ve Minimum Tax (AMT) was created in 1970 to ensure that high-income individuals cannot legally eliminate their tax liability. Unfortunately, it was not indexed for ina5on, with the eect that unless Congress acts to alter its thresholds, 30 million middle-class Americans will end up paying the AMT. According to the CBO, this would yield $103 billion in scal year 2013. This policy eect is included in the total es5mate above. Aordable Care Act Taxes

The Aordable Care Act (ACA) imposes two new taxes in 2013: (a) a tax of 2.3 percent on the sale of medical devices, and (b) surtaxes of 3.8 percent on net investment income and 0.9 percent on labor income of couples making more than $250,00 and individuals making more that $200,000. There are concerns that the medical device tax will disadvantage U.S. manufacturers of devices and harm employment in the industry. The impact of raising taxes on higher-income Americans and small businesses is the same as under the income tax. These policies will raise taxes in FY 2013 by $18 billion. Payroll Tax Holiday

The temporary reduc5on in the payroll tax was enacted for 2011 and extended in 2013 in an akempt to s5mulate job growth with likle apparent success. If it expires, it will raise total payroll taxes by roughly $86 billion. Tax Extenders

Each year Congress typically extends myriad business tax provisions. While not always included in the scal cli discussion, failure to extend these would add an addi5onal $65 billion in 2013.
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Fiscal Cli Spending

Sequester

The debt limit deal (Budget Control Act of 2011) included cuts to defense and non-defense spending totaling $1.2 trillion over 10 years. These cuts are poor policy across the board and not targeted and not focused on the en5tlement spending that is the real budget problem. They were never intended to occur, but rather to spur agreement on beker policies. The rst $109 billion of these cuts in funding will take eect on January 2, 2013 distributed roughly equally between defense discre5onary spending cuts of 9.4 percent, non- defense discre5onary cuts of 8.2 percent, and Medicare spending cuts of 2 percent. Select Federal Programs Subject to Sequestra,on Program Medicare Hospital Insurance Trust Fund Military Aircran Procurement Department of Defense, Opera5ons and Maintenance Na5onal Ins5tutes of Health (NIH) Rental Assistance (Tennant and Project- Based Educa5on for the Disadvantage Special Educa5on Children and Families Services Programs FEMA Disaster Relief Centers for Disease Control (Non-Defense) Funding Level ($ millions) 245,140 54,189 41,266 30,711 28,254 15,742 12,640 9,908 7,076 5,657 Percentage Reduc,on (%) 2 9.4 9.4 8.2 8.2 8.2 8.2 8.2 8.2 8.2 Es,mated Cut ($ millions) 4,903 5,093 3,879 2,518 2,302 1,291 1,036 812 580 464

Source: Oce of Management and Budget, h6p://www.whitehouse.gov/sites/default/les/omb/assets/legislaAve_reports/stareport.pdf

Medicare Physicians Reimbursements

Under the Sustainable Growth Rate (SGR) formula physicians in Medicare will receive a cut of 27 percent in their reimbursements for a total reduc5on of $10 billion. It is widely recognized that if such cuts occur, physicians will reduce their Medicare prac5ces, endangering the access of seniors to needed care. Unemployment Insurance

In response to the Great Recession, Congress expanded the generosity and extended the dura5on of unemployment insurance. These expansions end on December 31, 2012, although Congress has already begun reducing their generosity and the economic recovery has caused some states to reach unemployment rates low enough to exit the expanded benets.

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The Economic Eects of the Fiscal Cli

Douglas Holtz-Eakin & Ike Brannon l July 2012*
Execu,ve Summary The U.S. faces a $600 billion scal cli at the end of 2012 that includes a $440 billion tax increase and $108 billion in across-the-board spending cuts. Going over the scal cli will likely result in a recession if the administra5on and Congress fail to act. The nega5ve scal shock exceeds Gross Domes5c Product (GDP) growth in any year over the past two decades, and when considering economic mul5pliers, the contrac5on could approach ten percent, which would amount to the biggest year-to-year decline since 1932. This upper- bound es5mate would result in a loss of 10 million jobs, according to the administra5ons methods. Failing to extend the 2001-2003 tax cuts would not only increase taxes on every single taxpayer in the country but would also put millions of lower middle class households who are not currently paying taxes back on the tax rolls at a rate of neen percent, and restore the marriage penalty. For workers and small businesses in the top tax brackets, the eec5ve marginal tax rate for manyif not mostof these would spike to above and beyond 50 percent of their income in taxes. There are signicant economic consequences to going over the scal cli. Using conven5onal methods, we es5mate that a 6 percentage point drop in GDP triggered by a jump o the scal cli would increase unemployment by 2 percentage points, or to over 10 percent, resul5ng in an addi5onal 2.8 million people unemployed, with large losses in California, Texas, Florida, and New York. An increase the top eec5ve rate from 35 percent to 42 percent would lower the probability that a small business entrepreneur would add to payrolls by roughly 18 percent. For those that do manage to hire, the growth in payrolls would be diminished by over 5 percent. The increase in tax rates would reduce the probability that a small business undertakes expansion by nearly 15 percent, and reduce the capital outlays of those who do by almost 20 percent.

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Introduc,on It is now widely recognized that the United States faces a scal cli a combina5on of tax increases, federal spending cuts, and debt management decisions that will arrive simultaneously at the end of 2012 unless Congress and the Administra5on take ac5on. In this brief breakdown, we document the scale of the poten5al scal shock, provide a range of es5mates for the resul5ng macroeconomic impacts, and detail the impacts on key sectors of the economy. To an5cipate the results the scal cli represents a $600 billion nega5ve scal shock that would likely cons5tute the nal nail in the con of the tepid economic expansion the U.S. economy has experienced the past three years. Unless the Administra5on and Congress act, the likely outcome will be a new recession. The Fiscal Cli The scal cli is a combina5on of tax increases, spending cuts, and a debt ceiling increase that will occur at the end of 2012.1 The most prominent tax provisions are the personal tax rates that resulted from passage of the so-called Bush tax cuts of 2001 and 2003, the 15 percent tax rate on dividends and capital gains, and the elimina5on of the so-called marriage penalty, among other items. In addi5on, the two-percentage point reduc5on in payroll taxes the payroll tax holiday will expire. Congress will also need its annual patch of the alterna5ve minimum tax to limit its impact to 3 or 4 million households instead of the 50 million or so who would owe the tax as result of inexorable bracket creep. Finally, a plethora of business tax provisions the so- called extenders -- such as the research and experimenta5on tax credit and tax incen5ves for biodiesel fuel produc5on will need to be renewed. In addi5on, taxes passed in the Aordable Care Act are slated to come into eect in 2013. The overall size of the pending tax increase is $440 billion. On the spending side, the failure of the so-called Super Commikee created by the Budget Control Act of 2011 resulted in a mandatory sequestra5on across the board cuts to defense discre5onary spending, non-defense discre5onary spending, and Medicare spending totaling roughly $108 billion dollars. The sequestra5on would take eect in January 2013. Addi5onally, Congress will face the need for a doc x that boosts Medicare reimbursement rates to an acceptable level and the extension of unemployment benets from the standard 26 weeks to its current 52 weeks. The scal cli is quite high, as the total of tax increases and spending
1 At the 5me of this dran, we believe that the debt ceiling increase can plausibly be deferred to February or March of

2013. For that reason we focus our discussion on the tax and spending provisions. www.AmericanAc,onForum.org

decreases set to take eect without further Congressional ac5on exceeds $600 billion in 2013, according to the Congressional Budget Oce 2. The majority of the cli is tax increases and represents a poten5ally drama5c scal policy shock. An Enormous Fiscal Shock To put the size of the scal cli into perspec5ve, consider that the U.S. economy will produce over $15 trillion worth of goods and services in 2012, or about two percent (or roughly $300 billion) more than it produced last year. In other words, the level of contrac5onary scal policy that would hit the U.S. economy were we to hit the scal cli without any resolu5on is roughly twice the es5mated economic growth of 2012. In fact, the nega5ve scal shock presented by the scal cli exceeds Gross Domes5c Product (GDP) growth in any year over the last two decades. That, however, simply scales the size of the ini5al contrac5on to GDP and thus understates the true impact the tax increase and concomitant spending reduc5ons would have on the economy. Most macroeconomists believe that the response of consumers and businesses to scal policy amplies its impact on the economy through a so-called mul5plier eect. If the mul5plier is equal to 1.5, then a $1 tax cut to a small business would ul5mately result in a total of $1.50 in addi5onal GDP. The size of mul5pliers is controversial and we do not akempt to enter that debate. Instead, we note that former Council of Economic Advisers chair Chris5na Romer and her husband, Paul Romer, es5mate in a paper published in the American Economic Review that the correct mul5plier to use when es5ma5ng the impact of discre5onary tax policy is roughly three.3 If tax and spending impacts are roughly the same, then the eect of the expira5on of tax cuts and looming rescissions would trigger a decline in the economy approaching ten percent, which would amount to the biggest year-to-year decline since 19324. The administra5on argues that a percentage point of growth would yield 1 million addi5onal jobs. According to a report authored by Drs. Chris5na Romer and Jared Bernstein, a rela5vely conserva5ve rule of thumb that a 1 percent increase in GDP corresponds to an increase in employment of approximately 1 million jobs. According to the authors, this has been the rough correspondence over history and matches the [Federal Reserves] FRB/US model reasonably well.5 Thus, the upper bound es5mate is equivalent to 10 million jobs lost. These es5mates are intended as an upper bound, not a literal forecast. However, assuming even more modest mul5pliers leads to the same qualita5ve conclusion: a recession. The Congressional Budget Oce, unprecedentedly, projected that the expira5on of the tax cuts would lead to a recession in the rst half of 2013 as well, with economic growth some four to six percentage points below where we would be if we were to promptly come to a resolu5on of the scal cli for 2013 by keeping the tax cuts in place.6

2 Economic Eects of Reducing the Fiscal Restraint that is Scheduled to Occur in 2013, Congressional Budget Oce, May

22, 2012. CBO calculates the eec5ve reduc5on in spending plus the increase in taxes represented by the scal cli to be slightly above $600 billion.
3 Romer, Paul and Chris5na Romer: The Macroeconomic Eects of Tax Changes. American Economic Review 100(3),

763-801, 2010.

4 We arrived at this number by applying the es5mated mul5plier of three to the roughly $600 billion tax cli, arriving at

$1.8 trillion, or 12 percent of 2012 GDP of $15 trillion.

5 hkp://www.poli5co.com/pdf/PPM116_obamadoc.pdf 6 CBOs mul5plier implicit in these calcula5ons is roughly 1. The dierence between 4 and 6 depends on whether one

looks at all of 2013 (4 points) or just the rst half of the year.

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The Fiscal Cli: Jobs and Small Businesses Failing to extend the 2001-2003 tax cuts would not only increase taxes on every single taxpayer in the country but would also put millions of households who are not currently paying taxes back on the tax rolls. It would also restore the marriage penalty; a move that would make two middle class earners who are contempla5ng a marriage hesitate, as doing so would increase their tax bill by thousands of dollars. Allowing the tax cuts to expire would also reduce the incen5ve to work for millions of householdsand not just the upper-income and small business owners at the top brackets. The welter of welfare and en5tlement programs made available to the poor and the near-poor (and drama5cally expanded over the past three years), combined with their onen rapid phase-outs, creates a system where the lower middle class faces a perniciously high implicit tax rateonen exceeding forty percenton any addi5onal earnings they might receive from addi5onal working.7 Repealing the en5rety of the Bush tax cuts would re-impose a neen percent federal tax rate on millions of households that were taken o the tax rolls en5rely in the 2001 tax cut, further reducing their gains from working. For workers and small businesses in the top tax brackets, the repeal of the Bush tax cuts would push the eec5ve marginal tax rate for manyif not mostof these above and beyond ny percent once state taxes, the Medicare tax, and the phase-outs of certain deduc5ons and credits are taken into account.

7 See, for instance, Eugene Steuerle, Marginal Rates, Work, and the Na5ons Real Tax system. Tes5mony before the

House Ways and Means Commikee, June 27, 2012, or Brill, Alex and Holtz-Eakin, Douglas, Another Obama Tax Hike. Wall Street Journal, February 4, 2010. www.AmericanAc,onForum.org 9

The Aggregate Jobs Impact What happens to jobs? To gauge the impact, we can use Okuns law to es5mate the impact that the drop in GDP would have on employment. Okuns law suggests that for every two percent that the economy is below poten5al GDP, the unemployment is one percent higher.8 If we follow the lead of the Administra5on and assume that poten5al GDP growth is approximately equal to our current growth rate of 2 percent9, then a 6 percentage point drop in GDP triggered by a jump o the scal cli would increase unemployment by 2 percentage points, or to over 10 percent. This translates to an addi5onal 2.8 million people unemployed.10 The exact 5ming of the impacts is dicult to discern. While the scal cli itself occurs in January 2013, workers, rms, and investors will begin to an5cipate the probability that the scal shock will occur in advance of that date. Accordingly, one would expect the nega5ve impacts to begin to arrive in late 2012. Job Impacts by State Not all states are impacted equally by going over the scal cli. One would expect larger state labor markets to bear the brunt of the declines. We es5mate that California would lose over 320,000 jobs, Texas would lose over 230,000 jobs, and Florida and New York about 170,000 jobs. In contrast, Alaska, Vermont, and Wyoming would each suer a decline of less than 7,000 jobs. (See the Appendix for a state-by-state es5mate of the distribu5on of the job losses.) The Impact on Small Business The more deleterious eect on economic growth should this occur would come from the imposi5on of sharply higher tax rates on small businesses. Most U.S. businesses le their taxes not as corpora5ons but as individual workers. The U.S. tax code encourages this in a variety of ways, and for good reason. The alterna5ve, the corpora5on income tax, imposes two dierent layers of taxa5on on business income, which ends up being taxed both at the corporate level (at a combined federal, state and local rate in excess of 39 percent, the highest among the 33 countries that cons5tute the Organiza5on of Economic Coopera5on and Development) and then at the personal level when companies distribute dividends. Being taxed as a so-called pass-thru in which business income is passed directly to an individuals return removes the double-tax. Allowing the 2001-2003 tax cuts to expire would increase the cost of doing business for nearly every single small and medium-sized business in the country, threatening millions of jobs. Senator Charles Grassley of the Senate Finance Commikee noted that over 20 million workersor over neen percent of our work forceare employed by businesses that will see an increase in their tax rates should the lower tax rates on the top two tax rates be allowed to expire. 11 The Joint Commikee on Taxa5on es5mates that small business income cons5tutes 53 percent of the income reported by taxpayers earning more than $250,000, and 34 percent of all reported income above $1 million.

8 For a recent analysis of Okuns law and its hazards (and durability) as a forecast tool, see Knotek, Edward S, How

Useful is Okuns Law? Published by the Economic Review, Federal Reserve Bank of Kansas City, 2007, p. 73-103.

9 The average annual GDP growth for the last century is 3.1 percent, but some former Administra5on economists

suggest that a lower growth in the labor force and a possible short-term diminu5on in produc5vity growth may have nudged poten5al growth below the long-term average.
10 In the current labor force of approximately 155 million, 142 million of which are currently employed, each percentage

point increase translates to roughly 1.4 million jobs. on the Senate oor on February 2, 2010.

11 Senator Charles Grassley: Treasury Secretary Downplays Impact of Tax Increases on Small Businesses, Remarks given

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In our recent research, we es5mated that leeng the top two tax rates sunset would have a substan5al impact on the workers of small businesses.12 For example, an increase in the top eec5ve rate from 35 percent to 39.6 percent would lower the probability that a small business entrepreneur would add to payrolls by roughly 17 percent. Similarly, for those that do manage to hire, the growth in payrolls would be diminished by roughly 5 percent. Put dierently, the heavier burden of taxa5on that is in principle directed at higher income taxpayers would be shined toward workers by hiring less, paying less, or some combina5on of both. Other things being the same, this is neither a progressive shin nor suppor5ve of growth.13 In the same way, the same tax hike also aects incen5ves for capital expenditures, reducing the probability that a small business undertakes expansion by 14 percent, and reducing the capital outlays of those that do by 19. As these expansionary incen5ves are muted, the demand for capital goods is diminished thereby shining the burden to workers and investors in those rms. Summary Reaching the scal cli would be a calamity for the economy. The Congressional Budget Oces es5mate that the cli would be in excess of $600 billion means that nearly every perspec5ve on the impact of scal policy would lead one to conclude that economic growth would slow drama5cally, if not actually reverse. If we take the administra5ons own stated assump5ons 14 as to the economic impacts of such a policy shock a conserva5ve es5mate is that the ranks of the unemployed would increase by nearly three million, pushing the unemployment rate over ten percent. Small businesses and entrepreneurs are especially sensi5ve to increases in marginal tax rates. The scal clis looming tax increases would lower the probability that a small business entrepreneur would add to payrolls by roughly 18 percent and diminish the growth in payrolls by over 5 percent for those that do manage to hire. The higher rates would reduce the probability that a small business would undertake expansion by nearly 15 percent, and reduce the capital outlays of those who do by almost 20 percent. The $600 billion nega5ve scal shock would likely cons5tute the nal nail in the con of the tepid economic expansion the U.S. economy has experienced the past three years.

12 See Ike Brannon and Douglas Holtz-Eakin, The Taxa5on of Small Business: Pass-Though En55es, American Ac5on

Forum, forthcoming.

13 One would expect slightly smaller impacts on those facing an increase from 33 percent to 36 percent. 14 For a recent discussion see Bernstein, Jared, Are We Really Breaking the Law? On The Economy, March 12, 2012.

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Appendix 1: Jobs Lost by State Due to Fiscal Cli State Alabama Alaska Arizona Arkansas California Colorado Connec5cut Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachuseks Michigan Minnesota Mississippi Missouri Lower Upper Bound Bound 39,024 139,371 6,718 23,994 54,480 194,573 25,364 90,585 324,572 1,159,187 49,486 176,735 34,774 124,192 8,095 28,910 166,558 594,850 85,236 304,414 12,049 43,033 14,191 50,681 118,529 423,316 57,974 207,051 31,034 110,835 27,685 98,875 37,290 133,177 37,910 135,392 12,904 46,085 56,627 202,238 63,919 228,282 83,957 299,845 55,219 197,212 23,993 85,690 55,065 196,661 State Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming Lower Upper Bound Bound 9,398 33,564 19,192 68,544 23,705 84,660 13,854 49,478 82,081 293,146 17,103 61,082 171,964 614,156 83,086 296,736 7,443 26,584 105,939 378,354 33,558 119,850 35,867 128,096 117,573 419,905 9,745 34,802 38,502 137,508 8,420 30,072 56,283 201,010 230,952 824,828 24,957 89,131 6,718 23,993 80,614 287,906 63,511 226,825 14,754 52,694 56,392 201,398 5,739 20,495

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Fiscal Cli Scorecard

The scal cli is now broadly appreciated as an economic threat, and increasingly viewed as a recipe for a recession. There are seven legisla5ve components of the scal cli. The House has passed three bills addressing por5ons of this $539 billion disaster, reducing the risk of recession.

Fiscal Cli Recession Scorecard (As of November 12, 2012) 2013 Budget House Impact (% Ac,on Taken GDP) $225 billion (1.3%) $86 billion (0.5%) $18 billion (0.1%) $65 billion (0.4%) $109 billion (0.6%) $26 billion (0.2%) $10 billion (0.1%) $539 billion (3.0%) H.R. 8 N/A H.R. 2 N/A H.R. 5652 N/A N/A Reduced recession risk Economic Impact AOer AcPon Taken (% GDP) None -$129 billion (-0.8%) None $98 billion (0.6%) None -$39 billion (-0.2%) $15 billion (-0.1%) -$281 billion (-1.7%) Economic Impact Senate AOer AcPon Taken Ac,on Taken (% GDP) N/A N/A N/A N/A N/A N/A N/A Recession -$338 billion (-2.0%) -$129 billion (-0.8%) -$27 billion (-0.2%) $98 billion (0.6%) -$164 billion (-1.0%) -$39 billion (-0.2%) $15 billion (-0.1%) -809 billion (-4.8%)

Fiscal Cli Threat

2001/2003 Tax Laws & AMT Payroll Tax Holiday New ACA Taxes Tax Extenders BCA Sequester Unemployment Insurance Medicare Doctors (SGR) Total (% GDP)

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The Taxa:on of Small Business: Pass-Through En::es

Douglas Holtz-Eakin & Ike Brannon l July 2012
Introduc,on Americans have always been very entrepreneuriala majority of Americans will start a business at some point during their career, and there are many important legal as well as cultural advantages that set America apart from the rest of the world when it comes to business forma5on.15 In most jurisdic5ons and in most professions it is quite easy to set up a business and the American culture lionizes the small businessman, two things that are not at all common elsewhere in the world.16 So it is hardly surprising that a large number of individual tax returns each year report that some por5on of their income comes from owning, opera5ng, or par5cipa5ng in a business. In 2009, nearly 23 million returns reported some amount of business income.17 The tax code does not tax sole-proprietorships, partnerships, or S- corpora5ons as businesses. Instead the income is passed through to the individuals tax return to be taxed; thus these en55es are referred to as pass-through en55es. These pass-through en55es play an outsized role in the U.S. economy. Together, these three types of en55es reported revenue of nearly $13 trillion in 2008, 86% of our $15 trillion economy. 18 However, the current tax rates aec5ng these small businesses are set to increase in 2013 unless Congress and the administra5on act to extend the so-called Bush tax cuts of 2001 and 2003 for another year. The expira5on of these tax rates would not only increase the tax bills for millions of Americans but it will also cause taxes to go up on millions of small businesses. In the short term, the tax increase threatens the already-tepid economic expansion of the past three years. Over the longer term, the higher marginal rates depress job growth and investment in small businesses.

15 Bowers, Brent: The Dog Who Breathed a New Business. New York Times, 6 June 2007. 16 For an illuminaAng discussion on Americans inherent advantages for business creaAon see The United States of Entrepreneurs,

The Economist, March 12, 2009.

17 Gleckman, Howard: Small Business and Taxes. Tax Policy Center, September 27, 2011. 18 Data from the 2008 IRS StaPsPcs of Income; 2008 is the most recent year from which there is data.

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We es5mate that the impact of raising the top two tax rates would be severe, with output falling by roughly the current rate of economic growth, and the unemployment rate jumping to nine percent. Over the longer term there would be permanently impaired incen5ves for small businesses to hire and invest. What is a Pass-Through? Businesses that incorporate as a C corpora5on are obliged to pay taxes directly on the prots they earn. The average combined federal, state and local tax on corporate prots in the U.S. is 39.2 percent, the highest in the Organiza5on for Economic Coopera5on and Development (OECD). Once a rm pays its taxes it can retain the prots to nance expansion, buy back outstanding stock (and thereby pushing its stock price higher) or else pay dividends to its shareholders, or some combina5on thereof. However, this is only the rst layer of taxes on the return to equity investments. If a company pays out a dividend then the shareholder has to pay the 15 percent dividend tax, or if it buys more of its own stock to boost the price then the accompanying capital gain tax bill is layered on. The result of this double taxa5on is that the actual eec5ve tax rate for capital investmentthat is, the propor5on of a dollar invested in the stock of a company that ul5mately gets paid to the governmentcan exceed ny percent. This has a damaging impact on investment and growth. Nobel Laureate Robert Lucas es5mated that our capital stock of produc5ve plant and equipment would be Oy percent larger today if we did not tax capital income, which would result in an economy trillions of dollars larger than todays.19 However, smaller en55es can avoid the hazard of double taxa5on by organizing as a pass-through en5ty. Sole proprietors, S-corpora5ons and partnerships are examples of this small business legal structure. In a pass- through business, the business itself does not show any prots. Instead, the prots merely pass through the company to be distributed to the various owners. The distributed prots of pass-through en55es are taxed at the ordinary income tax rates. Under this system each dollar of prot is taxed once and only once, at the tax rate of the owner of the capital. The tax penalty associated with the C corpora5on means that this corporate form is essen5ally reserved solely for the largest businesses in the country, where the need to tap into global credit markets outweighs the tax penal5es inherent in the form. Small businesses instead organize as pass-throughs.20

19 David Levy: Interview with Robert E. Lucas jr. The Region, June 1993. 20 There are legal and governance restricAons on pass-through enAAes. For instance, S corporaAons can have no more than 100

shareholders, who must be U.S. ciAzens or permanently reside in the U.S., while for large partnerships the governance structure can become unworkable.

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The Business Impact of the Presidents Proposed Tax Increases Recently, President Obama proposed to raise taxes on those who earn over $250,000 a year by extending the 2001 and 2003 tax laws only for those under that level. In prac5ce this amounts to raising the top two tax brackets: from 33 percent to 36 percent and from 35 percent to 39.6 percent, respec5vely. According to the Tax Policy Center, over 70 percent of all tax lers in the top two brackets report at least some business income on their return, and over one-third of all income in those two brackets represents business income.21 For people par5cipa5ng in a small business, the income they report might be, and usually is, quite dierent from the actual income that they have at their disposal. For instance, a sole proprietor repor5ng $400,000 a year might be pueng $200,000 of that back into the business, leaving his family the remaining $200,000 (minus the tax bill) to live on. The typical shareholder of an S-corpora5on is in a similar situa5on, only with less cash. While the company needs to assign each dollar of prots to a shareholder for tax purposes, it does not necessarily need to return those prots to the shareholders. For instance, S-corpora5on banks onen retain a large por5on of prots to use as capital, and may choose to distribute dividends just large enough for its shareholders to cover all, or even just a por5on, of their annual tax obliga5ons for holding the stock. In both of these examples, the higher tax rate makes it more dicult for small businesses to accumulate capital for investment, thus reducing their ability to expand while also slowing produc5vity, employment, and economic growth. The Impact of Raising Taxes on Small Businesses As noted above, higher taxes will impede the ability to invest in a small business. In addi5on, nearly twenty ve million Americans work for small businesses that will have their taxes go up under the presidents proposal, according to data from the Joint Commikee on Taxa5on (JCT) and the Na5onal Federa5on of Independent Businesses (NFIB).22 That represents more than one out of every six people currently employed. This tax increase would be approximately $80 billion a year, according to the JCT, or $820 billion in the next decade.23 Macroeconomic Impact on Jobs To provide an es5mate of the impact this would have on the economy we borrow from the research done by Chris5na Romer, President Obamas head of the Council of Economic Advisers, and her husband Paul Romer.24 In their work they es5mate that the scal mul5plierhow much an incremental change in economic ac5vity would result from a change in spending and/or taxesto be roughly three. Therefore, the $80 billion tax increase for small businesses and other earners with an income over $250,000 a year would contract the economy by roughly $240 billion, or 1.6 percentage points of GDPclose to the level of economic growth thus far in 2012.25
21 Tax Policy Center, table T-10-0186. DistribuAon of Business Income by Statutory Marginal Rate, 2011. 22 Senator Charles Grassley, Senate Finance Commi6ee Hearing, February 2, 2010. 23 Joint Commi6ee on TaxaAon, List of Expiring Tax Provisions, 2012-2022. 24 Romer, Paul and ChrisAna Romer: The Macroeconomic Eects of Tax Changes. American Economic Review 100(3), 763-801,

2010.
25 Bureau of Economic Analysis, NaAonal Income and Product Accounts, GDP esAmates, First Quarter 2012 (third esAmate).

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To es5mate how such a diminu5on in growth would impact employment, we follow the lead of the Administra5on and invoke Okuns law, which suggests that for every two percentage point change in GDP there is a one percent change in employment in the same direc5on.26 By this metric, the Obama tax increase would push unemployment back to nine percent, the equivalent of 1.2 million jobs. Impacts to States Not all states are impacted equally by the looming tax increases on small businesses. One would expect larger state labor markets to bear the brunt of the declines. We es5mate that California would lose over 140,000 jobs, Texas would lose over 100,000 jobs, and Florida and New York about 75,000 jobs. In contrast, Alaska, Vermont, and Wyoming would each suer a decline of less than 5,000 jobs. (See the Appendix for a state-by- state es5mate of the distribu5on of the job losses.) Long-run Impacts on Small Business There is substan5al evidence that personal income taxes aect the desire of entrepreneurs and small rms to hire and invest. Using results from previous research suggests that leeng the top two tax rates sunset would have a substan5al impact on the workers of small businesses. 27 For example, an increase in the top eec5ve rate from 35 percent to 39.6 percent would lower the probability that a small business entrepreneur would add to payrolls by roughly 17 percent. Similarly, for those that do manage to hire, the growth in payrolls would be diminished by roughly 5 percent. Put dierently, the heavier burden of taxa5on that is in principle directed at higher income taxpayers would be shined toward workers by hiring less, paying less, or some combina5on of both. Other things being the same, this is neither a progressive shin nor suppor5ve of growth.28 In the same way, the same tax hike also aects incen5ves for capital expenditures, reducing the probability that a small business undertakes expansion by 14 percent, and reducing the capital outlays of those that do by 19. As these expansionary incen5ves are muted, the demand for capital goods is diminished thereby shining the burden to workers and investors in those rms. Conclusion Pass-through en55es are a pervasive legal form of small businesses in America. Accordingly, the recent insistence on raising the top two individual income tax rates will have signicant impacts on businesses. It is not an especially propi5ous 5me to be raising taxes on small businesses and pass-through en55es, given the tepid economic climate. We es5mate that the impact of raising the top two tax rates would be severe, with output falling by roughly the current rate of economic growth and unemployment jumping to nine percent. Over the longer term there would be permanently impaired incen5ves for small businesses to hire and invest.

26 For a detailed discussion of Okuns law see Knotek, Edward S, How Useful is Okuns Law? Economic Review, Federal Reserve

Bank of Kansas City, 2007.

27 Carroll, Robert, Douglas Holtz-Eakin, Mark Rider, and Harvey S. Rosen. 2000. Income Taxes and Entrepreneurs Use of Labor.

Journal of Labor Economics 18(2) (April):324-351. Carroll, Robert, Douglas Holtz-Eakin, Mark Rider, and Harvey S. Rosen. 2000. Entrepreneurs, Income Taxes, and Investment. In Joel Slemrod (ed.), Does Atlas Shrug? The Economic Consequences of Taxing the Rich. NY: Russell Sage FoundaAon, pp. 427-455.
28 One would expect slightly smaller impacts on those facing an increase from 33 percent to 36 percent.

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Appendix: Job Losses By State

Jobs Lost (Thousands) Upper Lower Bound Bound 17.3 3.0 24.1 11.3 144.0 22.0 15.4 3.6 73.9 37.9 5.3 6.3 52.5 25.7 13.8 12.3 16.5 16.8 5.7 25.1 28.3 37.2 24.5 10.7 24.5 107.8 18.6 150.5 70.6 899.9 137.3 96.2 22.5 461.6 236.6 33.4 39.6 328.2 160.6 86.1 76.8 103.2 104.7 35.7 156.7 176.9 232.7 152.8 66.7 152.8 Resul:ng Employment Rate Lower Bound Upper Bound State 8.2 7.8 9.0 8.1 11.6 8.9 8.6 7.6 9.4 9.7 7.1 8.6 9.4 8.7 5.9 6.9 9.0 8.0 8.2 7.6 6.8 9.3 6.4 9.5 8.1 12.4 12.0 13.2 12.3 15.8 13.1 12.8 11.8 13.6 13.9 11.3 12.8 13.6 12.9 10.1 11.1 13.2 12.2 12.4 11.8 11.0 13.5 10.6 13.7 12.3 Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming Jobs Lost (Thousands) Lower Bound 4.2 8.6 10.6 6.1 36.4 7.6 76.2 36.9 3.4 47.0 14.9 15.9 52.1 4.3 17.1 3.7 25.0 102.4 11.0 3.0 35.7 28.2 6.6 25.0 5.2 Resul:ng Employment Rate

State Alabama Alaska Arizona Arkansas California Colorado ConnecPcut Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachuse^s Michigan Minnesota Mississippi Missouri

Upper Bound Lower Bound Upper Bound 26.4 53.5 65.9 38.0 227.3 47.3 476.4 230.4 20.9 294.0 93.1 99.3 325.8 27.2 107.1 23.3 155.9 640.0 69.0 18.6 223.4 176.1 41.1 155.9 2.6 7.1 4.7 12.4 7.5 10.0 7.5 9.4 10.2 3.8 8.1 5.6 9.2 8.2 11.8 9.9 5.1 8.7 7.7 6.8 5.4 6.4 9.1 7.7 7.6 6.8 11.3 8.9 16.6 11.7 14.2 11.7 13.6 14.4 8.0 12.3 9.8 13.4 12.4 16.0 14.1 9.3 12.9 11.9 11.0 9.6 10.6 13.3 11.9 11.8 11.0

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The Economic Impact of the Medical Device Excise Tax

Michael Ramlet, Robert Book, and Han Zhong | May 2012
Introduc:on The Medical Device Excise Tax (device tax) is a tax on all medical devices sold in the United States and a component of the Aordable Care Act (ACA), President Obamas signature legislaAon. The device tax will soon be center stage in the Congressional healthcare debate. A Ways and Means commi6ee markup of repeal legislaAon this week will be followed by a oor vote in the House of RepresentaAves in June. The device tax debate highlights the economic impact of the ACA. The device tax pays, in part, for the enAtlement expansions in the ACA. The 2.3 percent tax will be applied to all medical devices sold in the United States, including both U.S.-made and imported devices. The only explicit exempAons are for eyeglasses, contact lenses, and hearing aids. The Congressional Budget Oce (CBO) anAcipates the tax will generate over $20 billion in new tax revenue between 2013 and 2019. While not scheduled to begin unAl 2013, the economic impact of the device tax is already being felt. The arAcial joint manufacturer Stryker announced plans to cut 5 percent of its global workforce (currently at over 20,000 employees) in order to reduce costs to pay the tax.29 In this paper, we esAmate the full economic impact of the tax on medical device industry employment, invesAgate the taxs eect on startups and small businesses, and evaluate the implicaAons for U.S. leadership in the medical device industry. Medical Device Excise Tax is a Tax on Jobs The medical device industry relies on conAnuous innovaAon to provide new and improved treatments for paAents, as products may have a marketable life of only a few years. In order to compete globally, companies must a6ract elite talent from the elds of medicine and engineering to perform research and development. In 2010, it is

29 Stryker to cut 5% of workforce, Detroit Free Press, November 11, 2011: h6p://www.freep.com/arAcle/20111111/

BUSINESS06/111110345/Stryker-cut-5-workforce.

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esAmated that the industry spent 23 percent of its revenue on wages and compensaAon 30 and employed over 474,000 employees.31 To oset the revenue loss due to the excise tax, medical device companies will likely have to absorb the cost of the tax as a reducAon in their net revenue for the devices they sell. Note that excise taxes are taken as a percentage of a manufacturers revenue. Therefore regardless of whether a company generates prots, the tax is enforced at the same rate. This is tremendously damaging to companies that have low prot margins or operate with losses during a given year. Companies that make a prot already pay a 35 percent federal corporate tax and 5 to 10 percent state corporate tax on income. On average, this excise tax takes another 5 percent cut to prots.32 Combined, medical device companies pay 45 to 50 percent of their prot in taxes. Figure 1, is an illustraAve example of how the new excise tax and exisAng corporate taxes would impact current medical device companies.

In the short term, most of the revenue reducAon from the excise tax is likely to be absorbed by the device industry in the form of reduced payroll employment. If the enAre revenue reducAon was absorbed by the medical device industry, job losses could reach as high as 47,100, or 10 percent of the total industry employment. This scenario is unlikely as some revenue is expected to be recouped through higher prices at a cost to paAents.

30 Samadi N. IBISWorld Industry Report 33451b: Medical Device Manufacturing in the US. June 2011. 31 NaAonal American Industry ClassicaAon System (NAICS): #325413, #334510, #334517, #339112, #339113, #339114, #339116 32 h6p://www.massdevice.com/news/numbers-how-medical-device-tax-shakes-out?page=2

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To more accurately project the likely reducAon in employment, we esAmated the relaAonship between revenue and employment in the industry.33 Through our analysis, we found that an average of 1.205 direct industry jobs are lost per year for each $1 million reducAon in industry revenue that year.34 This esAmate takes into account only direct employment by the medical device industry. Notably, a porAon of the revenue from that industry ows through to suppliers of goods and services from other industries. To esAmate this impact, we subtracted total revenue from value added by the industry, to obtain the dollar value of inputs supplied by other industries. The average raAo of the value of inputs to value added over the period of our data is 1.658. Output per job in 2002-2010 was 1.332 Ames higher in the device industry than in the overall economy supplying these inputs.35 Overall, this indicates addiAonal 2.210 jobs will be lost in other industries for every job lost in the medical device industry. This likely underesAmates the impact for two reasons. First, the input raAo has increased steadily from 1.54 in 2002 to 1.86 in 2010; the annual gure decreased only twice in that period, and each Ame the subsequent increase was larger in magnitude than the preceding decrease. The raAo is projected to rise even further in future years, to 1.94 by 2015.36 Second, producAvity per job in the medical device industry has been increasing faster than in the rest of the economy, from 1.072 Ames the average in 2002, to 2.058 Ames the average in 2010. There is no reason to expect this trend will reverse, but by using the average over that period we are being cauAous. For this reason, our esAmates for job loss in supplier industries should be viewed as somewhat conservaAve. The annual job loss projecAons are shown in Table 1. The CBO projects that annual collecAons from the device tax will reach $3.4 billion by 2019, leading to an esAmated reducAon of 4,000 direct industry jobs. Table 1: Annual Es:mated Jobs Losses Due to the Medical Device Excise Tax Year 2013 2014 2015 2016 2017 2018 2019 CBO Projected Tax Collec:ons ($million) 1,800 2,700 2,800 3,000 3,100 3,200 3,400 Direct Medical Device Industry Employment 2,200 3,300 3,400 3,600 3,700 3,800 4,000

As noted above, the reducAon in industry revenue (or equivalently, the amount of tax collected) from a 2.3 percent tax is not simply 2.3 percent of whatever revenue would have been otherwise, since both prices and quanAAes sold could change as a result of the tax. We assume that CBO took these factors into account when making their projecAons. If they did not, job losses would be larger.

33 Samadi, op. cit. 34 We ran an ordinary least-squares regression of rst dierences (changes) in employment on rst dierences (changes) in

revenue (in millions of constant dollars). The result was a staAsAcally signicant coecient of 1.205 (with a t-staAsAc of 2.80).
35 This is the raAo of value added per job in the medical device industry to GDP per job in the overall economy. 36 Samadi, op. cit.

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AddiAonal jobs will be lost in other industries that supply medical device manufacturers; a conservaAve esAmate puts the minimum loss at an over 9,000 addiAonal jobs. Together this represents at least 13,000 jobs lost as a result of the medical device excise tax. The Device Tax and the Demise of Small Businesses Small businesses and startups in the medical device industry will have greater diculty adapAng to the excise tax burden. The structure of the device tax favors larger companies who are be6er posiAon to absorb the lost revenue as a result of lower xed costs and larger cash reserves. The tax could therefore be especially devastaAng to the 13,303 U.S. medical device companies with of 50 or fewer employees; 1,200 companies with 50 to 500 employees; and roughly 450 companies with fewer than 1000. Together these small to medium size rms represent over 91 percent of 16,424 U.S. medical device companies.4 The impact on small businesses is already visible in the dramaAc drop o in venture capital deals for medical device

companies in 2011 over 50 percent less than any of the previous ve years (Figure 4). The Device Tax Threatens U.S. Innova:on Leadership The medical device industry is uniquely American. The industry is dominated in size and scope by American rms, but future U.S. leadership depends on whether the regulatory and tax environment nurtures growth or suppresses innovaAon. The reality is that U.S. dominance in the industry is receding. As the regulatory cost of medical device development has increased and revenues have stagnated (Figure 4), the number of U.S. medical device rms has dropped considerably. Since 2008, the U.S. medical device industry has seen an annual 5 percent decline in the number of acAve companies (Figure 5). This annual decline is expected to conAnue and accelerate with new investment dollars going abroad, or to other industry sectors as a result of the medical device excise tax.

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A s Congress begins the debate over whether to repeal the medical device excise tax, the economic lesson is clear. If leu in place, medical device industry employment will decline, medical device startups and small businesses will decline, and U.S. leadership in the medical device industry will decline. The medical device excise tax is bad tax policy, bad economic policy and bad healthcare policy.

The Impact Of The Medical Device Excise Tax

The Medical Device Excise Tax in the Affordable Care Act will have a significant impact on America's small businesses and their ability to grow and hire. This new device tax will disproportionately hurt these businesses already struggling under the weight of a weak economy.

MID-SIZED BUSINESSES

91% OF MEDICAL DEVICE MAKERS ARE SMALL OR MID-SIZED

SMALL BUSINESSES

BUSINESSES WITH LESS THAN 1000 EMPLOYEES. 81% ARE SMALL BUSINESSES WITH FEWER THAN 50 EMPLOYEES

THIS ADDITIONAL 2.3% TAX TAKES AN ADDITIONAL 5% FROM PROFITS, HAVING A DIRECT IMPACT ON THE INDUSTRYS ABILITY TO GROW AND HIRE. THE DEVICE TAX WILL LEAD TO JOB LOSSES OF AT LEAST14,500 AND AS MANY AS 47,100.

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The Fiscal Cli

May 30, 2012 Douglas Holtz-Eakin The Congressional Budget Oce (CBO) kicked the budgetary hornets nest with its forecast that the U.S. faces a recession unless ac5on is undertaken to avoid the sharp tax increase and across-the-board spending cuts that will result from the sunset of the 2001/2003 tax laws and Budget Control Act (BCA) sequester, respec5vely. Of course, this is avoidable if Congress acts to not only avoid the cli that looms at the end of 2012, but also nally acts in a substan5ve way to deal with the long-term issues that con5nue to drive us toward this cli. The CBO notably points out that Congress ought to undertake real eorts to control the current and projected federal debt load. So, ideally one should subs5tute mandatory spending controls (en5tlement reform) for the sequester because mandatory spending is the budget problem and because the sequester exists only because the so-called super commikee did not agree on mandatory spending reforms. That would both eliminate the sequester component of the cli and take control of the U.S. scal future. Then, the explosive tax hike and damaging an5-growth tax policy should be replaced by a comprehensive, pro-growth and pro-compe55veness tax reform (see here). Viewed from a pure policy perspec5ve, this is a big deal. Given the con5nued weak state of the economic recovery, it is inconceivable that growth would survive the hit of such a sharp (4 percent of GDP) scal contrac5on. Combine that with the supply-side impact of sharply higher marginal rates, especially on the return to investment, and you have a recipe for the scal cli to induce an economic tsunami. The very fact that the CBO announced this dire forecast is proof of how serious the situa5on is. It is the rst 5me in memory that CBO has forecast a recession. Some will point out that the study was done at the request of a senator. True, but most CBO studies are in response to a request, and they dont include a recession forecast. This is without ques5on a big deal. The only aw with the CBO report is that it len the impression that the danger does not arise un5l the end of the year. Unfortunately, the economy is not that lucky. Instead, as investors contemplate the possibility that the tax rate on dividend income will rise from 15 percent to 44 percent, they will churn out of dividend-paying stocks, and perhaps out of equi5es altogether. Financial-market turbulence will translate to an economic downshin well in advance of December. Similarly, the sequester will begin to haunt the federal contrac5ng community well in advance of January. As agencies squirrel away funds in an5cipa5on of the cuts, contractors will get the bad news in August and September as the new scal year approaches. This will be exacerbated by the unwillingness of the Obama administra5on to provide any guidance whatsoever on the mechanics and the ill-advised commitment of Senate Majority Leader Harry Reid. Get ready for a bumpy late summer and fall. The conven5onal wisdom is that a complete x is a bargain too grand to be struck in 2012, and that is probably right. But there ought to be a bridge over the scal cli so that Novembers electoral winners can choose a permanent direc5on for the U.S. in 2013. That bridge would merely serve as a way to avoid the sequester, as an extension of current tax policy, and as a commitment to scal sanity. Interes5ngly, the House has already passed a bill to subs5tute mandatory spending reforms for the 2013 sequester, will soon pass a temporary extension of the 2001/2003 tax laws, and has in place a budget that ul5mately eliminates federal debt en5rely. Under regular order, the next step would be for the Senate to do exactly the same thing, a conference commikee would resolve dierences, the president would whip votes needed to pass the result and the U.S. would be spared a self- inicted economic wound. Unfortunately, Majority Leader Reid refuses to take any ac5on and the president is missing in www.AmericanAc,onForum.org 25

ac5on en5rely. It is hard to make the process work with two-thirds of the leadership indierent to the economic welfare of the country. I keep hearing that poli5cs are broken. Maybe. But shouldnt Reid at least put the key in the igni5on and see if it can get started? The scal cli is real and the CBO report shines a bright light on the danger. The tax and spending threats that cons5tute the scal cli are in5mately connected to the longer-run budget issues that must be addressed. There may be no consensus regarding the resolu5on of those larger, permanent issues but there should be an obvious bipar5san path to avoiding the near-term danger.

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Three Fiscal Flashpoints that Can Cause a Recession

October 6, 2012 Douglas Holtz-Eakin Policymakers, business, markets, and households alike are more aware than ever of the dangers posed by the federal governments scal aairs. Indeed, there are three ashpoints that pose dis5nct dangers and require dierent solu5ons. Unfortunately, the vast majority of discussion and commentary intermix the three in problema5c ways. The rst danger is the scal cli a combina5on of $440 billion in automa5c tax increases (sunset of the payroll tax holiday, sunset of the 2001 and 2003 tax laws, alterna5ve minimum tax, and new taxes from the health care reform) and $200 billion in spending cuts (the sequester from the Budget Control Act of 2011, cuts to doctors trea5ng Medicare pa5ents, and the end of augmented unemployment benets). Going over the scal cli would cons5tute a shock to the economy equal to 4 percent of GDP a guaranteed recession. Addressing this danger requires being good stewards of the economy so as to get to the spring of 2013 without a scal shock that leads to recession. At present, it appears to be a fait accompli that the payroll tax holiday will sunset, placing a premium on extending the rest of current policy for one year tax rates, unemployment insurance (UI) benets, Medicare payments, spending cuts to avoid disaster. Thats good, because Congress strongest impulse and greatest skill is to kick tough issues down the road. The only excep5on is that the blunt, dangerous, across-the-board cuts in 2013 discre5onary spending should be replaced with longer-term reduc5ons in mandatory outlays the part of the budget the so-called super commikee was supposed to control in the rst place. The second danger is the need to raise the federal debt limit, likely in February or March. The limit is a symptom of another real problem spending; and therefore, any increase needs to be accompanied by corresponding decit reduc5on. The events of the summer of 2011 bear stark witness to the poli5cal toxicity of this mix. The right solu5on is a small increase in the debt ceiling, matched with decit reduc5on, to buy 5me un5l August 2013. The nal danger is the fundamental unsustainability of the federal budget. Aner four consecu5ve years of trillion dollar decits and the accumula5on of $6 trillion in new debt, the future is even bleaker. Len unchanged, the exploding debt burden will drag down the economy and assure a Greek-style nancial crisis. It is the single most important economic and na5onal security threat. This simply cannot be kicked down the road. If serious progress is not made by August 2013, markets will (correctly) conclude that the poisonous U.S. poli5cal climate precludes dealing with serious problems even in the honeymoon period of a new Congress and Administra5on. The ra5ngs agencies will collec5vely downgrade the U.S., capital will be impaired across the nancial system, credit will freeze and a second Great Recession will ensue. It is folly to lump these eorts together. Trying to deal, for example, with the longer-run scale and progressivity of the tax system raising top rates in the lame duck will prove too dicult because it must be accompanied by serious en5tlement reforms. The result will be gridlock and a na5on hurtling over the scal cli. Tying the scal cli to the debt ceiling increase is equally folly. Tax hike and spending cuts that will necessarily be part of the discussion surrounding the debt ceiling increase are at odds with the need to avoid a scal shock. The right strategy is to make sure that the underlying poli5cal issues will not get in the way. This means aver5ng the scal cli and geeng to 2013 unscathed, pushing the debt ceiling modestly with equal parts decit reduc5on, and giving the new Congress and Administra5on a clear agenda to focus on the real problem: burgeoning debt driven by unchecked spending increases. Fundamental tax and en5tlement reform will sweep away any future scal clis and debt ceiling debates. It is the top priority and the sooner they are dealt with, the beker. Douglas Holtz-Eakin is president of American AcPon Forum and former CBO director under George W. Bush. www.AmericanAc,onForum.org 27

Holtz-Eakin Discusses Fiscal Cli on Fox News On the Record with Greta Van Susteren

Fox News On the Record with Greta Van Susteren July 20, 2012 hkp://5nyurl.com/agwyw3f

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An Economic Guide to Cli-Diving

Douglas Holtz-Eakin & Cameron Smith l December 2012
Introduc,on The U.S. faces three dis5nct policy challenges that pose dangers to the na5ons economic recovery and the well being of future genera5ons. The rst and most immediate danger is the scal cli, a combina5on of $395 billion in tax increases and $145 billion in spending cuts set to take eect at the end of the year. The second issue is the need to raise the federal debt limit, which appears to be possible to defer to at least February or March of 2013. The third, and most perilous, is the fundamental unsustainability of the federal budget, which must be addressed seriously by August 2013, or risk a signicant downgrade in the credit ra5ng of Treasury securi5es.37 This short paper focuses on the scal cli, the conuence of an array of scal policies occurring at the end of 2012. In par5cular, there are tax increases: (1) the sunset of the 2001 and 2003 so-called Bush tax cuts, (2) the need to patch the alterna5ve minimum tax (AMT) to keep it from impac5ng the middle class, (3) the sunset of the payroll tax holiday, (4) new taxes under the Aordable Care Act, and (5) the usual end-of-year tax extenders exemplied by the research and experimenta5on tax credit. In addi5on, there are mechanis5c spending cuts: (1) the across-the-board cuts (sequester) required under the Budget Control Act of 2011, (2) cuts to reimbursement rates for physicians under Medicare, and (3) expira5on of the extended unemployment insurance benets. While the scal cli phenomenon has emerged as a near-obsession recently, considerable disagreement remains about the consequences of cli diving failing to avoid the scal cli. In par5cular, some have argued that cli diving is benign either because the cli itself is an illusion it is really a gentle slope or because policymakers have the cartoon-like power to reverse going over the cli without hieng the abyss. Our analysis suggests that both arguments are undercut by the key role that would be played by nancial markets. The reality of cli diving would have signicant impact on nancial markets, impair asset values, exacerbate credit stringency, and amplify the direct eects on the main street economy. Moreover, contrary to what some have asserted, such impacts cannot be unwound by retroac5vely legisla5ng away the scal cli. Accoun5ng for the nancial market analysis suggests that the economic downturn could easily be as large as 3 percent and persist beyond the two quarters needed to qualify as a recession as they commonly understood. Impacts on the Real Economy38 Taken at face value, the scal cli is a very large nega5ve policy shock. The tax increases are nearly $400 billion and the spending cuts about $145 billion. The total, $540 billion are roughly 3.0 percent of Gross Domes5c Product (GDP). For perspec5ve, trend economic growth at present appears to be less than 2.0 percent, but certainly nowhere close to 3.0 percent.

37 Credit ra5ng agencies have cited poli5cal gridlock as the key threat to the current AAA ra5ng. If the rst year

honeymoon period of the new Administra5on and Congress passes without progress, that gridlock will be an evident reality and downgrade will follow.
38 This sec5on draws heavily on hkp://americanac5onforum.org/topic/new-study-examines-economic-eects-scal-cli

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Accordingly going over the scal cli means a recession. A conven5onal way to summarize the impact is the mul5plier. If the mul5plier is equal to 1.5, then a $1 tax hike (or spending cut) would ul5mately result in a total of $1.50 in lost GDP. The size of mul5pliers is controversial. However, if one uses the es5mates of (former chair of the Council of Economic Advisers) Chris5na Romer and Paul Romer the mul5plier is roughly three.39 If so, going over the scal cli would trigger a decline in the economy of $1.6 trillion roughly 10 percent of GDP the biggest year-to-year decline since 1932. These numbers represent the upper bound for a variety of reasons. First, the mul5pliers may be much smaller. But even so, a mul5plier of 1.0 yields a $540 billion decline a recession of 3.0 percent.40 Secondly, the dura5on of the recession is unclear. If Congress adopted a new scal policy quickly, the recession may be short-lived. So, for example, a 3.5 percent recession at an annual rate that lasted only through January and was quickly reversed would be a mere blip on the growth path of the economy. Third, some argue that the actual impacts could be minimized by administra5ve ac5ons that, for example, did not change tax withholding (a de facto extension of current law) or slowed the decline in federal outlays. But there will be limits to what an Administra5on can do without statutory authority. In sum, a straight-forward reading of the impacts on the real economy suggests a signicant recession that could be both short-lived and shallower with 5mely administra5ve and prompt legisla5ve ac5ons. Put dierently, this raises the hope that going over the scal cli could be reversible and have a modest overall impact. Financial Market Eects The poten5al for signicant nancial market fallout substan5ally changes the outlook for cli diving. First, unlike the measured collec5on of taxes and reduc5ons in spending over a year, nancial markets can react essen5ally instantaneously. Hence, the moment it becomes obvious that the economy is going over the cli, one would an5cipate that equity markets will fall, and the riskiness of various classes of debt will be re- evaluated. Figure 1 displays the 5ming and scale of the impacts of the 2008 nancial crisis. Note that equity markets (as measured by the Wilshire index) declined quickly and sharply, later to be followed by the real-economy recession reected in payroll employment and Gross Domes5c Product. Recall as well, that the real economy declines were essen5ally from the nancial shock there was no sharp tax increase or sudden spending cut involved.

39 hkp://emlab.berkeley.edu/~dromer/papers/RomerandRomerAERJune2010.pdf 40 The Congressional Budget Oce projects that cli diving will result in a 0.5 percent loss in real GDP. See hkp://

cbo.gov/publica5on/43694

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Unlike budgetary moves that can be reversed, these kinds of impacts on market condence in the outlook are durable. 41 This is especially problema5c in light of the fact that nancial markets remain less the fully recovered from the recent crisis. Thus, if policymakers drive the economy over the scal cli, the pure mul5plier analysis on the real economy should be augmented by nega5ve nancial market impacts that are poten5ally quite large and long-lived. Financial market impacts are not easily quan5ed, as most business cycle models do not include a nancial sector. One might argue that markets need not react strongly to going over the scal cli. Aner all, the logic goes, markets can an5cipate the quick reversal of the tax hikes and spending cuts in January 2013. Unfortunately, the logic simply does not hold together: why should markets be condent of a deal in January when the poli5cal fac5ons failed to nd one in December?

41 Many analysts akribute at least part of the slowing in the 2nd half of 2011 to the declines in consumer condence that

occurred as a result of the poli5cal bakle over raising the debt limit.

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About the American Ac:on Forum

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