The new age of anxiety

Article Highlights

  • #Taxmegeddon is coming. And on top that, #Congress will likely hit the #debt limit again around the end of the year.

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  • Uncertainty about taxes and fiscal policy is likely to skyrocket by the end of the year.

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  • #Taxmageddon is the result of the extreme shortsightedness of President #Obama and the #Democrats” – Kevin Hassett

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This article appears in the May 14, 2012, issue of National Review.

Taxmegeddon is coming. This grim prophecy refers to the scheduled termination of a wide array of tax policies at the end of this year. The list is staggering. It includes the expiration of the Bush-era tax cuts, the end of the payroll-tax holiday, and the start of the new healthcare surtax and the Medicare payroll-tax increase. On top of all of that, Congress will likely hit the debt limit again around the end of the year.
"Uncertainty about taxes and fiscal policy is likely to skyrocket by the end of the year. This heightened uncertainty is cause for significant pessimism about the second half of 2012." Kevin A. Hassett

While few observers expect Congress to do nothing, uncertainty about taxes and fiscal policy is likely to skyrocket by the end of the year. This heightened uncertainty is cause for significant pessimism about the second half of 2012.

Economists have long known that uncertainty can have large negative effects on economic activity. If a business does not know what its tax rates will be next year, it will have a hard time getting excited about a big expansion.

While uncertainty in principle is likely harmful, there has been very little hard evidence on the matter, until recently. A recent path-breaking paper, by Stanford economists Scott R. Baker and Nicholas Bloom along with University of Chicago economist Steve Davis, fills that gap. The authors compile a unique index of policy uncertainty, which draws on news coverage of uncertainty in policy decisions, the number of federal-tax-code provisions set to expire, and the disagreement among forecasters about economic variables one year in the future. They use this index to estimate the impact of policy uncertainty on the economy, finding massive negative effects.

The nearby chart shows their index of policy uncertainty from 1985 to 2012.

Click here to see a larger version of the chart.

In general, policy uncertainty has been higher on average since the beginning of the millennium than it was in the previous 15 years. As expected, the major spikes include the 9/11 attack, the 2003 invasion of Iraq, and the on set of the financial crisis. As even a casual observer would expect, uncertainty has become a much bigger problem under President Obama. The most recent and highest increase occurred in August 2011, reflecting the uncertainty surrounding the debt limit, the work of the supercommittee, and the credit-rating downgrade by S&P.

The authors document the negative effect of uncertainty on the economy in their paper. Their results imply that a 112-point rise in their policy-uncertainty index, which occurred between 2006 and 2011, would reduce real GDP by 3.2 percent and employment by 2.3 million jobs. The uncertainty effects would be especially focused on private investment, as business decision-makers wait for clarity before beginning new projects.

The dramatic spike last summer, the authors argue, is likely a key explanation for the slower economic growth that was posted then. That fact is especially chilling as we look ahead. Taxmageddon will put far more policies on the table. The debt limit will be in play, but so will everything else. Even though the uncertainty index has been steadily dropping in the past couple of months, it is all but inevitable that it will increase sharply as the debate surrounding the tax cuts heats up. When it does, uncertainty will likely break the all-time record set last year, which could easily take a percentage point or two off of top-line GDP growth.

Taxmageddon is the result of the extreme shortsightedness of President Obama and the Democrats, who extended current tax policies for only two years back in 2010. The latest research suggests that the economy will suffer severely this year for that  shortsightedness.

Kevin Hassett is a senior fellow and director of economic policy studies at AEI.

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