“Fiscal Drag” Dissipated Late in 2013

The executive and legislative branches of government control federal taxation and spending. But the Federal Reserve pays close attention to fiscal policy because it influences the economy and labor market.

Without advocating particular positions, it is possible to identify general fiscal conditions that would promote the ongoing recovery of the labor market. As Atlanta Fed President Dennis Lockhart explained in a September 2013 speech, public policy can foster economic dynamism “by removing obstacles to growth and entrepreneurship and contributing pro-growth actions that address investment in human capital and productive infrastructure.”

It is important for elected officials to set fiscal policy on a sustainable long-term path. Establishing a course on which the ratio of federal debt to gross domestic product (GDP) eventually stabilizes or declines is critical to ensure longer-run economic growth and stability, Lockhart pointed out. Yet even as policymakers address longer-range fiscal sustainability, they should avoid unnecessarily adding to forces that are slowing the economic recovery.

Those forces in 2013 included a “fiscal drag” consisting of the effects of tax increases early in the year, reduced spending, the partial federal government shutdown, and the impact of fiscal policy uncertainty on business investment and consumer spending.

The Congressional Budget Office (CBO) estimated that federal spending cuts lowered employment by between 300,000 and 1.6 million jobs. Meanwhile, the partial shutdown of the federal government in October reduced fourth-quarter GDP by an estimated 0.25 to 0.5 percentage point. In total, cuts in government spending and tax increases likely lowered economic growth in 2013 by as much as 1.5 percentage points, according to the CBO.

The good news: the worst of the fiscal drag appeared to be over as 2013 ended. In December, Congress reached a budget compromise and in January 2014 passed a comprehensive spending bill. Further, the fiscal situations of states and municipalities generally improved during 2013, likely reducing the need for further cuts in employment and investment.


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