The Fiscal Cliff and its effects on U.S economy and employment

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The Fiscal Cliff and its effects on U.S economy and employment



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The Fiscal Cliff and its effects on U.S economy and employment.

As policy makers and economists debate on reviving the vital United States (U.S) economy and declining employment rate, focus has been shifted to the U.S budget and amendment of tax policy decisions. The discussion has been controversial with a section of policy makers proposing a tax cut on income, capital gain and dividends as the engine in reviving the economy while others proposing an increase in tax rate to reduce the inordinate budget deficit of over $700,000billion. This has also brought up an interesting yet very crucial heated argument within the congress with the democrats advocating for tax increment to help cut down the budget deficit while the republicans call for reduced government spending.

Policy makers are also faced with a major challenge. There is a tussle of whether this high tax rates on income and Medicare tax should be allowed starting from 2013, immediately after the Bush tax cuts expires.

This infamous increase on the tax rate and reduction of the massive federal government spending is what is referred to as fiscal cliff. My goal in this paper is to research the impacts of the fiscal cliff policy on U.S economy and employment and show how the fiscal cliff policy, though it might help cut down the budget deficit by about $300,000billion by 2020, it will adversely affect the economy and negatively affect the standard of living of citizens.

To achieve this goal, I have organized my paper into four sections. In the first section, I provide an account on background information that lead to introduction of the fiscal cliff. In the second section, I will discuss on the effect of fiscal cliff on the U.S economy, I end my paper with the third section on effects of fiscal cliff on employment then conclude the fourth section with my perception of how such a policy will impact negatively in the long run and give brief proposals on how the government can help cut down the deficit balance.


The tax cuts and holidays that were enforced under the Bush administration with the then president, George. W. Bush in the year 2002 being the pioneer is considered to lead to the fiscal cliff. The tax cut policy was aimed at a reduction on the tax rate on income, dividends, capital gains, reduction in marriage penalties, and elimination of estate taxes and increasing of tax credit to children from 500 to 1000 U.S dollars per child. Unfortunately, the tax cut policy had a life span of 10 years only meant to expire by the end of 2012.

At the beginning of 2013, all tax rates on estates, payrolls, dividends, capital gains will rise and other provisions like that of the child care credit are said to be cut back or completely eliminated. This was seen as the only option left after the Obama administration failed to find a solution on how to reduce the large budget deficit. The other desperate move that amalgamates with increase in tax rate to give the brief definition of fiscal cliff is the reduction of government spending. The goal of deficit reduction will be characterized by approximately 60% of contributions from tax increment and the other 40% from reduced federal outlay. This report gives in summary the effects of such measures on employment, consumption, real GDP, economic growth as well as the budget deficit in general.

Effects of tax increment on economic growth.

Most classical economists argue that economic growth of a country can only be achieved through domestic spending, where there are massive consumptions by the public and households. An increase in tax on the other hand reduces disposable income by 3.9% annually, which sequentially reduces spending, especially on businesses that depend on discretionally dollars such as restaurants, retail shops and entertainment. An increase in tax therefore has a negative impact to the economy thereby reducing its growth. Not forgetting that it discourages entrepreneurs and private investors who spur growth as well as employees are demotivated thus reducing their productivity in the different economic sectors

Economic growth is also geared by the saving culture, though not in excess to avoid some economic effects such as the ratchet effect. Businesses, entrepreneual activities and expansions are mainly if not all financed by savings. Projections by economists have shown that a reduction of savings by 2.7% is expected. Savings in the form of retained earnings, undistributed profits, purchasing of bonds and stocks will all be affected negatively thus reducing the real GDP by around 0.3% per annum which equates to an approximate of $ 530billions yearly affecting the economic growth.

High investment tax rate discourages the free flow of capital and therefore damages the long term economic growth. The effect will not be immediately felt but the future developments will be hampered. Less capital flow means less productivity hence fewer wages thus affecting the economic growth in general. On the contrary, some argue that increase in tax, increase government revenue in the short run but eventually revenue collection will tend to decrease due to reduced public spending as well as reduced labor supply. Other factors may be Involvement of citizens in illegal businesses or unregistered ones for tax evasion and avoidance or simply reduce taxpayer compliance. Research has shown that there is a possibility of increased deficit of $ 137billion per year as from 2013 to 2017.

Some economists argue that higher taxation raises the cost of equity financing providing an incentive for leverage and borrowing rather than equity financing for corporations. During recessions, leverage can be of great help to corporations thus making them withstanding the tough economic downturns.

Effects of reduced federal spending on economic growth.

The government; through their expenditures inject money in the economy through government projects that stimulate the economy. The congressional budget office estimates that federal spending will be reduced by $103billions. Reduction in government spending will reduce the general public expenditure. A federal spending reduction in some of non-vital sectors or some of the unnecessary ventures i.e. financing of unproductive spending like wars will reduce the budget deficit since most of the deficits in the us comes from financing military activities.

Effects of tax increment on employment.

The congressional budget office (CBO) recently projected that employment would increase by 2 million more jobs under the scenario where the budget deficit is not reduced. With the tax increment policy being in effect, employment and living standards will be adversely affected. Many of the U.S innocent citizens are at the verge of becoming jobless. This is because of the reduced spending forcing the economy into recession thus in turn making the government dream of consolidating income tax impossible. The congressional research paper reveals a 2.8 million loss of jobs in the earlier years as the number decreases to 1.4million jobs as the years go by. Not only does the tax increase affect businesses that lead to laying off of many employees but also a tax increase in income causes a disincentive to work forcing many employees substitute work time for leisure instead.

An increase tax rate on capital gain and dividends will reduce the cost of equity capital which discourages savings and reduces investments, making capital stock and investments to fall in the long run by 1.4% and 2.4% respectively( Robert and Gerald, 2012) retained business earnings that are aimed at business expansion. Business expansion leads to increased employment opportunities but if the retained earnings are reduced, business will find it so hard to expand killing the federal goal of unemployment reduction and a target inflation rate of not more than 2%. Projections have shown a loss of 0.5% in the job market which roughly is estimated at about 750000 jobs lost in the long run. This will reduce long run output and the net worth.

Higher taxation has been found to deter flow through businesses from hiring workers and also investing. A 5% point increase in the individual marginal tax rate was found to reduce the percentage if entrepreneurs who made new capital investments by 10.4% (Robert and Gerald, 2012).

Effects of reduced federal spending on employment.

The more the government spends, the more it stimulates the economy. During the 2008 financial crisis, an expansionary fiscal policy, known as the economic stimulus package launched by president Obama was aimed to kick start the economy out of recession. Amongst of the policies was direct funding of public works to create jobs directly to the U.S citizens. Government expenditure is through financing of government projects that consequentially leads to employment of citizens in the government projects. If such spending is reduced by 40% as stated by the congress, employment will be adversely affected. The government aims at reducing Medicare by 2%. This will affect the creation and retention of about 750000 jobs annually.


Currently, the U.S budget deficit runs at about $ 750 billion. This is quite a substantial amount which the government aims to reduce this amount to $ 400billions by 2020. Fiscal cliff policies if allowed possess unperceived danger in future. Some of the provisions particularly on increased tax rate in dividends and capital gains will adversely affect investment and capital stock by reducing the after tax return to investments. Other provisions like increase in income tax and Medicare tax on labor income of high income tax payers can be expected to reduce both disposable income and labor supply. This will force the economy into recession due to reduced spending.

With recession in place, unemployment and retrenchment of other employees will result forcing a slow economic growth. On my opinion, the implementation of such a policy is ironic since the main objective of the federal government is to minimize the unemployment rate by focusing on policies and decisions that spur economic growth. This study shows that higher tax rates will reduce output in the long run by 1.3% and employment will fall by 0.5%.

What the government should do is to reduce some of the unproductive spending, such as financing military activities in other nations. General reduction of federal finances will deeply affect state and local governments who are deeply tied in these federal finances. It will not be logically upright for U.S citizens to pay a great amount to the government in the form of high taxation yet in return receive unmatched expenditure and public services from the government. Many will opt not to comply in tax payments.

This tax austerity pushes the U.S economy far from the goals and objectives of federal reserves. Though the fiscal cliff will be seen as a way of reducing the budget deficit, I predict much more harm than good for this strong United States economy.

Work cited.

Robert Carroll and Gerald Prante. The Flow-Through Business Sector and Tax Reforms: the economic footprint of the flow through sector and the potential impact of tax reform, An Ernst and Young LLP report prepared for the S Corporation Association, April 2011. Print.

Congressional Budget Office. Economic effects of reducing the restraint scheduled to occur in 2013-May 2012. Print.

Robert Carroll and Geoffrey Gee. The 2001 and 2003 tax rate reductions: an overview and estimate of the taxable income response, National tax journal, vol. 61(3), pp. 345-364, 2008. Print.

Congressional Budget Office. The budget and economic outlook: fiscal year 2012 to 2022. January 2012. Print.

William M. Gentry and R. Glenn Hubbard. Success Taxes, Entrepreneurial Entry and Innovation, working paper no. 10551, National bureau of Economic Research, June 2004. Print.

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