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The public policy blog of the American Enterprise Institute
A new study from the San Francisco Fed estimates US budget policy will knock as much as one percentage point a year from GDP growth over the next three years. And 90% of the fiscal drag comes from higher taxes. The SF Fed:
Surprisingly, despite all the attention federal spending cuts and sequestration have received, our calculations suggest they are not the main contributors to this projected drag. The excess fiscal drag on the horizon comes almost entirely from rising taxes. Specifically, we calculate that nine-tenths of that projected 1 percentage point excess fiscal drag comes from tax revenue rising faster than normal as a share of the economy. … The CBO points to several factors underlying this “super-cyclical” rise, including higher income tax rates for high-income households, the recent expiration of temporary Social Security payroll tax cuts, and new taxes associated with the Obama Administration’s health-care legislation.
See, when an economy goes into a recession, fiscal policy automatically becomes expansionary. Income taxes fall, while unemployment insurance and Medicaid rise. Deficits increase. During upturns, the process reverses. Spending on safety net programs declines, and tax revenues rise. Deficits decrease.
During the Great Recession, fiscal policy was more expansionary than typical because of the stimulus, but since mid-2010, fiscal policy has reversed. Since then, federal fiscal policy has been much more contractionary than normal. Spending has fallen sharply, and tax revenue has grown faster than usual given the weak recovery.
Now time for some math:
1. The SF analysis assumes each increase in spending or decline in taxes has a corresponding impact on economic growth.
2. The Congressional Budget Office projects that the federal deficit as a share of GDP will drop 1.4 percentage points per year over the next three years. In other words, GDP will be 1.4 points lower each year because deficits will be smaller due to spending declines and tax increases. (That’s a full percentage point more than than the typical deficit decline of 0.4 points per year.)
3. That amount would fall slightly to 1.2 percentage points per year if sequestration spending cuts were reversed. So the rest of the drag comes from higher taxes.
Federal fiscal policy has been a modest headwind to economic growth so far during the recovery. This is typical for recovery periods and in line with the historical relationship between the business cycle and fiscal policy. However, CBO projections and our estimate based on the countercyclical history of fiscal policy suggest that federal budget trends will weigh on growth much more severely over the next three years. The federal deficit is projected to decline faster than normal over the next three years, largely because tax revenue is projected to rise faster than usual. Given reasonable assumptions regarding the economic multiplier on government spending and taxes, the rapid decline in the federal deficit implies a drag on real GDP growth about 1 percentage point per year larger than the normal drag from fiscal policy during recoveries.
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