November 13, 2012 Sequestration=Devastation? The fiscal cliff looms ahead
It could be quite the exaggeration to say that the coming fiscal cliff will devastate the economy, but it will certainly shift the U.S. economy from 1st gear (the current growth rate is only 2% in real, inflation-adjusted dollars) into reverse. The nonpartisan Congressional Budget Office and IHS Global Insight both estimate that if we go off the cliff the economy will drop 4% from a positive 2% growth rate to a -2% contraction.  The subsequent changes in business investment, and other secondary effects resulting from downturns in federal spending, would undoubtedly cut into Utah taxable sales (expect a decline of at least 4%).
Before we draw conclusions though, we must look at the crux of the problem at hand—the yawning gap between federal revenues (red) and expenditures (blue) in Chart 1 below. One coming event that will lead to a decrease in expenditures will be ending the war in Afghanistan. That would be good from several standpoints: 1) lower defense spending, and 2) fewer deaths and injuries that need to be covered by the Veteran’s Administration budget. However, fixing Afghanistan permanently would take another 10 to 50 years, and some of the consequences of careening off the fiscal cliff are immediate.
While something must be done in the near-term to bring these lines closer together, it is encouraging that over the past few periods it appears that expenditures have leveled out, while revenues are in a straight up trajectory (Chart 1). This may be due to the fact that the slow recovery is starting to gain traction.
While most economists agree that cutting our economic growth by 4% would not be a good thing at this time, compounding the situation is the fact that many federal grants and programs could be indiscriminately cut by about 8 percent.
In mid-October Juliette Tennert, Chief Economist from the Utah Governor’s Office of Planning and Budget, identified the 8% cuts from the hundreds of major federal grants. Below (chart 2) is a rearranged version of her more detailed table identifying the largest cuts and those that have the greatest impact Utah cities and towns (specific cuts to grants for cities will vary upon whether they utilized CBDG or EPA grants). The bottom line is that sequestration will cause federal spending in Utah to drop $100 million. Assuming a multiplier of 2.0 on a base of $100 billion economy, that means a loss of just 0.2% to the Utah economy. More worrisome for the state’s economy is the potential for major reductions at northern Utah’s Hill Air Force Base which could very well be double the federal grant impact amounts.
While this reduction in federal spending (sequestration) will take place relatively gradually, the more immediate result of a failure to compromise in Washington will be across the board federal tax increases if the 2001 Tax Relief Reconciliation Act (aka the Bush tax cuts) expires on December 31, 2012. As soon as January 1, 2013 or February 1, 2013, when the Treasury Department changes its withholding tables, the federal government could experience $535 annual increases in revenue (Chart 3).
Results from the Urban-Brookings Tax Policy Micro-simulation Model indicate that something less than $300 billion of these possible tax increases will hit the lower- and middle-classes (116 million families, bottom 73%). The balance—$235 billion in tax increases—will impact 42 million families with incomes more than $75,000. While the so-called “average” tax increase for a family will go up $300 per month, the median tax increase will be more like $150 to $200 per month.
Since powerful influences in congress represent each of these constituencies, it seems unlikely that congress will deadlock and go over the fiscal cliff. Yet, a year ago, a congressional “super committee’s” inability to hammer out a deal is what led to sequestration in the first place, and in August 2011, congress was unable to agree on expanding the debt ceiling on a timely basis, leading to a lowering of our debt ratings.
We can only hope that congress and the president can compromise before the New Year lest these huge impacts blindside an already weak recovery.
 “Financial Survival in a Time of Fiscal Peril”, The New York Times, October 17, 2012, F1.
 Source: Tax Policy Center