By Nick Mann | 23 August 2012

The package of spending cuts and tax increases set to take effect automatically in the US next year in the absence of an agreed budget could send the country back into recession, the Congressional Budget Office warned yesterday.

On January 1, the ‘fiscal cliff’ will abolish various tax cuts, including some in place since former president George W Bush, and introduce spending cuts across US government departments and agencies. It will come into effect unless Congress approves a new deficit reduction deal.

The congressional agency’s latest six-monthly economic and budgetary outlook advises Congress that the automatic package would reduce the US federal budget deficit by almost $500bn but would also lead to economic conditions in 2013 that would ‘probably be considered a recession’.

CBO director Douglas Elmendorf said the decision on whether the fiscal cliff takes effect would ‘play a crucial role in determining the path of the federal budget over the next decade and the outlook for the economy in the near term and beyond.

‘In the CBO’s judgement, the sharp increases in federal taxes and reductions in federal spending – that, under current law, are scheduled to begin in calendar year 2013 – are likely to interrupt the recent economic progress, resulting in what will probably be considered a recession,’ he added.

Gross domestic product would decline by 0.5% between the fourth quarter of 2012 and the fourth quarter of 2013, while the unemployment rate would rise to around 9% in the second half of 2013.

At the same time, the US deficit – which the CBO expects to total $1.1 trillion in the year ending September 30 2012  – would be reduced to $641bn.

The CBO contrasted this with an ‘alternative fiscal scenario’, where the Bush-era tax cuts were extended indefinitely and the spending cuts due to take effect on January 1 were averted.

In this case, the US federal government budget deficit would total $1bn but the country would steer well clear of recession. GDP growth would be 1.7% between the fourth quarter of 2012 and the fourth quarter of 2013, while the unemployment rate would be around 8% by the end of 2013.

In the longer term, the deficit would also be much lower if the fiscal cliff took effect, the CBO forecasts, averaging around 1% compared with 5% between 2014 and 2022.

At the same time, public debt would rise to 90% of GDP by 2022 – a level the CBO said would be ‘higher than at any time since shortly after World War II’. 

However, it noted that even if the fiscal cliff did occur, debt would still represent a larger share of GDP in 2022 than in any year between 1955 and 2009. Growth would begin again in late 2013, but the economy would continue to operate below its full potential until 2018.