Avoiding a New American Recession

CAMBRIDGE – The United States may be headed for a recession in 2013. Even if the country avoids going over the “fiscal cliff,” a poorly designed political compromise that cuts the deficit too quickly could push an already weak economy into recession. But a gradual phase-in of an overall cap on tax deductions and exclusions (so-called tax expenditures), combined with reform of entitlement spending, could achieve the long-run fiscal consolidation that America needs without risking a new recession.

The US economy has been limping along with a growth rate of less than 2% during the past year, with similarly dim prospects in 2013, even without the shock of the fiscal cliff.  That is much too weak a pace of expansion to tolerate the fiscal cliff’s increase in tax rates and spending cuts, which would reduce demand by a total of $600 billion – about 4% of GDP – next year, and by larger sums in subsequent years.

President Barack Obama’s proposed alternative to the fiscal cliff would substantially increase tax rates and limit tax deductions for the top 2% of earners, who now pay more than 45% of total federal personal-income taxes. His budget would also increase taxes on corporations, and would end the current payroll-tax “holiday,” imposing an additional 2% tax on all wage earners.

Together, these changes could lower total demand by nearly 2% of GDP. And the higher marginal tax rates would reduce incentives to work and to invest, further impeding economic activity. All of that could be fateful for an economy that is still struggling to sustain a growth rate of less than 2%.