The Drag Of Fiscal Policy On The U.S. Economy

by: Ironman at Political Calculations

Brian Lucking and Daniel Wilson of the Federal Reserve Bank of San Francisco have made news with their June 3, 2013 Economic Letter, in which they point the finger at a new source of drag on the U.S. economy: the U.S. federal government's fiscal policies, and President Obama's tax hikes in particular (emphasis ours):

While our estimates show that fiscal policy has held back the recovery slightly to date, the effect over the next three years looks much bigger. The CBO projects that the federal deficit as a share of GDP will drop 1.4 percentage points per year over the next three years. This projection would ease slightly to 1.2 percentage points per year if sequestration spending cuts were reversed. By contrast, our calculation of the historical-norm deficit decline through 2015 is 0.4 percentage point per year based on the CBO's output gap projections. This implies that the excess drag from the rapidly shrinking deficit would reduce real GDP growth annually by between 0.8 and 1.0 percentage point, depending on whether sequestration is reversed. Thus, with or without sequestration, fiscal policy is expected to be a much greater drag on economic growth over the next three years than it has been so far.

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. As Panel B shows, at the end of 2012, taxes as a share of GDP were below both their historical norm in relation to the business cycle and their long-run average of about 18%. However, over the next three years, they are projected to rise much faster than our estimate of the usual cyclical pattern would indicate. 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.

The timing of this particular economic letter from the Fed is cool, because we just did the analysis of the impact of the spending cuts and tax increases upon the U.S. economy in the first quarter of 2013. In that analysis, we found that the Fed's recent adjustments to its quantitative easing programs were working to offset the negative effects of those fiscal policies, which would appear to be the only reason the U.S. economy grew in 2013-Q1.

But more importantly, we also quantified the impact of both the spending cuts and the tax increases upon the nation's GDP. Our tool below focuses just on those components and estimates their relative share of negative impact:

Overall, for the first quarter of 2013, we find that the combination of government spending cuts and tax increases would reduce the United States' GDP by $184.5 billion from the previous quarter, which means the drag of the changes in the U.S.' fiscal policies upon the nation is roughly 1.2% of its GDP, which is close to what the Fed predicts with its model.

Of that fiscal drag on the United States' GDP, 8.5% may be attributed to the effect of government spending cuts at all levels in the U.S. - federal state and local. The remaining 91.5% of that decline is directly attributable to the tax hikes that went into effect in 2013, including the Social Security payroll tax hike, the various Obamacare tax hikes and President Obama's desired tax hikes upon high income earners and investments that were part of the fiscal cliff tax deal at the beginning of the year, all of which applied at the federal government level.

We therefore find that the actual results of the negative effects of the changes in U.S. federal government's fiscal policies are turning out to be pretty much right in line with what the Federal Reserve has predicted using its model.