Washington is in a dither over the fiscal cliff. The cliff consists of roughly $500 billion in tax increases that will occur on January 1, 2013 as the Bush-era tax rates expire, along with almost $100 billion in automatic cuts in government spending resulting from the sequester negotiated last year in the deal that extended the tax rates through 2012.[1]
According to conventional wisdom, the resulting drop in government spending and consumer demand will shock the economy, causing it to slow or possibly fall into a recession. While Americans are right to be worried about the economic effects of the fiscal cliff, the subject of that concern should be on the production side of the economy, not the demand side—especially over the long term.
Certainly, we can expect some short-term adjustments in the economy from a cut in federal spending as people leave federal jobs and projects for other work. But, as Milton Friedman pointed out in the 1960s, other things equal, a rise in revenue and drop in spending would reduce federal borrowing and free up saving for others to borrow and spend. There would be no effect on total demand unless the Federal Reserve were to slow its purchases of government debt in reaction to the fiscal shift, and that effect would be due to the change in monetary policy, not the fiscal policy by itself.
The real and very dangerous effect of the fiscal cliff is what the tax rate increases would do to production over the long term.
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