Fiscal Cliff or Stairway to Heaven?

by Stephen Fisher | Dec 13, 2012

Why would 50% of US Republican voters favor a tax rate hike now to pay for Obama's spending? The answer is that they are going to have to pay for it at sometime in the future, so now is as good a time as any.

This logic is not only simple and compelling, it also explains why the doomsday forecasts for the 'fiscal cliff' are rubbish and, moreover, that triggering the tax hikes and spending cuts associated with the expiry of the Bush Jobs for America legislation may actually BE GOOD for the US economy.

I have written about the Ricardian Equivalence doctrine previously.  This argues that economic agents are forward looking in their expectations for taxes and government budget deficit financing such that what matters is the present value of future taxes that need to be raised to finance a budget deficit today.  This means that government spending is NOT stimulatory since people need to save to pay for the necessary tax in the future.  Government spending is exactly offset by savings for future taxes.  

Viewed in this light, triggering the fiscal cliff should have little effect on US growth as it will simply collect taxes a bit earlier than expected while at the same time cutting spending.  People will adjust their asset portfolios to reflect the timing of taxes while keeping their consumption plans largely intact.  So while Ricardian Equivalence doctrine suggests that the effect of triggering the tax hike/spending cuts will be largely neutral, what good can come out of it?

It is well known that government deficit spending is not stimulatory, and that long-term deficit spending multipliers are actually NEGATIVE i.e..higher deficits reduce economic growth in the long term.  If you don't believe me, just look at Europe.  Triggering the tax hikes/spending cuts may permanently block the Obama deficit spending juggernaut.  If so, then the Fiscal Cliff may well turn out to be the Stairway to Heaven!

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