What Would Happen If We Let the Tax Cuts Lapse?



  • Extending the Bush tax cuts might boost the economy in the short run but would likely reduce output and income in the longer run
  • However, we’re not going to be able to cut spending and raise taxes without eventually causing a recession

In May the Congressional Budget Office released a report titled, “Economic Effects of Reducing the Fiscal Restraint That is Scheduled to Occur in 2013.” (Catchy title, eh?) It was widely reported that the CBO predicted that allowing the tax cuts to lapse (returning to higher tax rates) would lead to recession. As an example, the lead sentence in a widely cited AP report said, “A new government study released Tuesday says that allowing Bush-era tax cuts to expire and a scheduled round of automatic spending cuts to take effect would probably throw the economy into a recession.”

I’ve actually read the CBO report (surprise, surprise). There’s no question that the CBO projects that these higher taxes (and less government spending) will lower our growth rate and will likely result in a mild recession. But, there was much more to the report. Here’s what they say will happen if we simply continue on with our lower tax rates and overspending:

“Although removing or reducing the fiscal restraint scheduled to occur next year would boost the economy in the short run, doing so would reduce output and income in the longer run relative to what would otherwise occur.”

“If the scheduled fiscal restraint was eliminated by extending all current policies – not just in the short run, but for a prolonged period – debt would continue to rise much faster than GDP.”

“The longer the necessary adjustments in policies were delayed, and the more that debt increased, the greater would be the negative consequences.”

The CBO then describes what will happen if we continue on with our current fiscal policies:

  1. More of our savings would be used to purchase government debt rather than to finance investments in productive capital.
  2. Higher amounts of debt would necessitate higher interest payments.
    Higher interest payments would eventually lead to higher taxes or a reduction in benefits and services.
  3. “Rising debt would increasingly restrict policymakers’ ability to use tax and spending policies to respond to unexpected challenges, such as economic downturns, financial turmoil or international crises.”
  4. “Growing debt would increase the likelihood of a sudden financial crisis, during which investors would lose confidence in the government’s ability to manage its budget and the government would thereby lose its ability to borrow at affordable rates.”

The CBO seems to suggest that we should maintain our reduced tax rates (and maintain our spending levels), but commit to policies for the future that will get our deficit and debt in line.

Here are my thoughts:

  1. Give me that big piece of cake today. Three years from now, I’ll definitely start to diet. Or better yet, give me a big piece of cake today and I’ll tell my kids to diet in three years. You don’t seriously believe that we’ll stick to this, do you?
  2. Everyone says that we need to commit to changes in the future so that we have time to plan for these changes. Well guess what…we knew that tax rates were going up next year and we knew that the 2% reduction in our half of the payroll taxes were temporary. You see, we had notice, but it’s still not good enough.
  3. I’ll be the first to say that many of the changes in fiscal policy that will result in the “fiscal cliff” are not well thought out. But, at the same time, show me a plan that is going to be widely accepted. There isn’t one – unless it’s really far out and we don’t believe that it will affect us personally.
  4. We’re in a no-win situation. We have a ton of debt and a lot of promises that we’ve made. We’re not going to be able to cut spending and raise taxes without eventually causing a recession. (It would be awesome if that’s all it causes.) But, this “fiscal cliff” discussion is indicative of the way that everyone thinks: There is a desire to avoid all pain. It’s impossible. It can’t happen.

The idea that there’s an easy solution reminds me of the halftime reporter who interviews coaches at halftime. “Coach, it’s halftime and you’re losing 77-0. Members of your team seem to be fighting with each other. What adjustments are you going to make to win this game?”

McCombs Senior Lecturer Sandy Leeds provides analysis of key market issues on his blog, Leeds on Finance, where this article originally appeared.


The views expressed are those of the author and not necessarily The University of Texas at Austin.

About The Author

Sandy Leeds

Distinguished Senior Lecturer, Department of Finance, McCombs School of Business, The University of Texas at Austin

Sandy Leeds, CFA is a Distinguished Senior Lecturer at The University of Texas at Austin. He teaches graduate level classes in the MBA program and...

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