The Fiscal Cliff: a non-Keynesian Analysis

Much of the discussion and analysis of the fiscal cliff is purely Keynesian: incentives are ignored and it is assumed that moving money around has a multiplier effect (negative in this case, because it involves moving money “from the consumer” to the Treasury).

Here’s a back of the envelope on incentives:

• Emergency unemployment benefits are ended “prematurely”.  Keynesians say that end depresses the economy, but it really expands it because it reduces the pay people can receive by not working.  In terms of marginal tax rates for middle income people, this provision will lower them about 2.2 percentage points (see Chapter 5 of The Redistibution Recession, this is expressed as a percentage of total  compensation).
• “Bush rates” for individual income tax expire:  rates rise about 3 percentage points (using the same compensation units as above — not the usually units you see cited).
• The payroll tax cut expires: raises rates 1.8 percent points (same units as above).
• AMT hits a lot more people.  If the Bush tax cuts had not expired, that would probably rate rates about one point.  But the cliff  expires the Bush rates, so it is possible that adding on the AMT lowers rates.  So let’s call it zero.
• TOTAL: marginal tax rates for middle income people go up 2.7 points.  Their after tax share falls by 0.049 log points (that is, about 5 percent).

IF all of this happened (it won’t), my model predicts that the labor market shrinks 1.8-3.7 percent relative to the constant marginal tax rate baseline. At the baseline, the labor market grows at something like population growth (+1 percent over one year).  So maybe the labor market shrinks 0.8 – 2.7 percentage points in absolute terms.  That’s a noticeable recession, but much smaller than what happened 2008-9.

I doubt that the Bush rates expire on the middle class (the rich don’t count much in the employment statistics), so that entry can be forecast as zero.  So then marginal tax rates actually go down (the emergency UI expiration more than offsets the payroll tax cut expiration — see my book on this point), and the labor market grows a bit faster than one percent in absolute terms.

If the Bush tax rates were maintained (at least on the non-rich), and just part of the unemployment benefits were to expire, then marginal tax rates might edge up a bit.

In my view, the tax rates on the rich matter little for what happens to employment in the short run, because the rich don’t count much in the employment statistics.  They count much more in the spending and productivity statistics, which would be depressed by returning to the Bush rates for them.

What could be interesting is if we go over the fiscal cliff, have a mild recession, but the entry into that mild recession opens the spigots for still more help for the poor and unemployed (think ARRA), and turns a mild recession into a deep one (sound familiar?).

The bigger issue for the labor market in the medium term is what happens with the ACA.  If that goes in as planned, it should be a lot more depressing than the fiscal cliff (although I am still preparing my estimates here — not a simple law).