Modeling the Economic Impact of the Fiscal Cliff

November 27, 2012

Tax Hikes Would Chill Job Growth, Economic Recovery

Washington, D.C., November 26, 2012—The expiration of the tax provisions known as the “fiscal cliff” would seriously depress economic activity in the U.S., reducing output by almost ten percent over the next decade and affecting people of all income levels and tax brackets, according to a new analysis from the Tax Foundation.

Most estimates of the fiscal cliff’s impact significantly downplay the negative effects on future economic growth, failing to take into account the impact on workers and low-income households not directly hit by higher tax rates on capital gains and income in the highest brackets. Conventional analysis thus also dramatically overstates the amount of new government revenue to be gained from increasing tax rates.

“The fiscal cliff is mainly a tax cliff, and its impact on the economy will mostly come from undermining production, not because it lowers consumer demand or government spending,” said Tax Foundation Senior Fellow Stephen Entin. “The tax increases would simply make it harder, more expensive, and less desirable to produce goods and services in the United States.”

The increases in the tax rates on capital gains and dividends would produce the most harmful economic consequences by far, lowering economic output by more than 6 percent over the long term. This would create a drop of nearly 1.2 percent in hours worked (equal to about 1.5 million full-time equivalent jobs) plus a drop in the hourly wage of about 5.3 percent for those still working. That is equivalent to a loss of about 8 million jobs at unchanged wages.

On a static basis, these higher tax rates on capital income appear to raise $82 billion, but they would reduce economic output and payrolls by enough to cost the government $158 billion, after taking the economic consequences into account. These tax increases are all pain and no gain.

The tax increases on dividends, capital gains, and estates – and to a lesser extent the increases in the marginal tax rates – would raise the cost of accumulating capital, reduce productivity, and cut employment and wages. Most of the expected revenues would be lost to a weaker economy and lower income. To be pro-growth, any solution to the current deficit and the fiscal cliff must rely mainly on spending reductions and must avoid raising taxes at the margin, especially on capital formation.

Tax Foundation Special Report No. 205, “Diving off the Fiscal Cliff: An Economy on the Rocks” by Stephen Entin, is available here.

The Tax Foundation is a nonpartisan research organization that has monitored fiscal policy at the federal, state and local levels since 1937. To schedule an interview, please contact Richard Morrison, the Tax Foundation’s Manager of Communications, at 202-464-5102 or morrison@taxfoundation.org.

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