The Fiscal Cliff & What it Means for the Economy

Chubby is better! I came back from a great holiday visit with my grandchildren to a pile of depressing newspapers. A “deal” was reached only temporarily avoiding the fiscal cliff. Legislation providing aid to the many victims of Sandy in our region was postponed. However, there was also an article claiming that mortality rates actually fall as weight rises. Music to my tummy! Bring on the carbs! Maybe we’ll find that bigger deficits are actually good for the economy…

After expelling much hot air (the real reason for global warming) the folks in Washington extended the Bush-era tax cuts for all but those joint filers reporting more than $450,000 per year. These and other tax changes were made permanent, i.e., no expiration dates. Emergency unemployment benefits were continued for another year, but the “payroll tax holiday” was not, shrinking take-home pay by 2 percent for many workers.

The “deal” failed to address some huge issues. The nearly $110 billion in spending cuts that were supposed to start January 1 were postponed for two months. Also, the debt ceiling was not increased so that we might still hit a “fiscal wall” sometime in March, when the Treasury runs out of borrowing power. And if that’s not enough, the temporary funding measure that is keeping the government running expires on March 27. So the “deal” has done little to lift the uncertainty that is hobbling the economy, giving a whole new meaning to March Madness!

Making the tax changes permanent essentially takes taxes off the table in the deficit reduction deliberations – at least in the opinion of Republicans – thereby shifting the focus almost entirely to spending, especially entitlements. Late last year, there was some talk that Speaker Boehner and President Obama were contemplating replacing the Consumer Price Index (CPI) with the Chained CPI in calculating cost-of-living adjustments for Social Security and certain other items. This is worth a closer look.

The spending weights in the familiar CPI are updated only every two years. Hence, it tends to overstate inflation by understating the shift away from items whose prices are rising more rapidly, the so-called “substitution effect” from Economics 101. The Chained CPI adjusts the weights monthly, recognizing that people switch their spending from, e.g. hamburgers to hot dogs if ground beef prices rise faster.

The government uses the CPI to calculate annual increases for Social Security and Veterans’ benefits. It is also used to adjust federal income tax schedules to keep inflation from pushing taxpayers into higher brackets.

Over periods of several years, the Chained CPI has tended to rise 0.2 percentage points less annually than the official CPI. These small differences can add to big savings… paring roughly $200 billion from the federal budget deficit over the coming decade.

Treasury Inflation Protected Securities (TIPS) provide full protection from increases in the CPI. My guess is that existing TIPS will continue to use the conventional CPI but newly issued TIPS would use the chained version if the switch is made for entitlements.