Wednesday’s warning by the Congressional Budget Office (CBO) that the fiscal cliff is likely to push the economy back into recession should bring things sharply into focus for lawmakers. The CBO is correct that the fiscal cliff will lead to a recession, but its report contains faulty economic reasoning.
The analysis contained in the CBO report treats tax increases and federal spending cuts as equally harmful to the economy. That contradicts a foundational principle of economics: People respond to incentives.
Professor John Cochrane of the University of Chicago’s Booth School of Business points out that the CBO report misses badly on unemployment insurance, a topic exhaustively studied by economists, including The Heritage Foundation’s James Sherk. Cochrane writes:
What will the effect on output and employment be of ending 99 weeks of unemployment insurance? That’s part of the fiscal cliff, and the CBO’s analysis says that reducing unemployment insurance will lower GDP. Really? A standard economic analysis comes to exactly the opposite conclusion. Generous unemployment and disability means that some people choose to stay unemployed rather than take lower-paying jobs, or jobs that require them to move. So long as you stay unemployed, you get a check from the government. Subsidizing anything produces more of it. So, a standard analysis says that cutting back unemployment insurance lowers unemployment, and raises output and this part of the fiscal cliff analysis should go the other way.
Before you go all nuts on how heartless I am, keep the question in mind. I didn’t say what’s good or bad, I said what raises or lowers GDP and unemployment. The standard analysis of unemployment insurance says, yes, it raises unemployment and lowers GDP, but it provides important insurance for the truly needy and unfortunate. It’s something we do out of compassion even though it hurts us.
What’s obviously true about unemployment insurance is usually true of other government spending. When the government taxes one person and provides for another, it reduces the incentives for both of them to work or to invest in education, a new business, or career mobility.
For instance, if government provides health care to all citizens by taxing citizens who work, that twice reduces everyone’s incentive to work: earning an income is harder with higher taxes and is less important when someone else is paying for one’s health care. This does not mean that all transfer payments should be eliminated, but it does mean that they reduce GDP and employment.
Government spending is good when it pays for valuable public goods. We tax ourselves to provide a fair justice system, education for all, and protection from violence—not to stimulate the economy. As Congress and the President consider how to address the fiscal cliff, they should understand that reducing the size of government through lower taxes and spending systematically raises private GDP, but increasing spending does not.