Psychological Defaults and the Fiscal Cliff

Dec 23, 2012 by

In December 2012, the United States was alarmed about the possibility of the nation “going over the Fiscal Cliff” – a number of temporary tax reduction programs were set to expire at the end of the year. Namely:

  • Expiration of the Bush/Obama tax cuts
  • Expiration of delays to the Medicare Sustainable Growth Rate
  • Expiration of the Social Security payroll tax holiday
  • Enactment of budget cuts agreed to within the Budget Control Act of 2011

While there are obvious economic impacts to both extending these initiatives and to letting them sunset, perhaps the most interesting thing is how this debate has been framed. It could be said that “payroll taxes will increase unless Congress acts” or that “Americans will no longer have a payroll tax holiday unless Congress acts”. The media has chosen to frame this change as a potential future loss, rather than the potential discontinuation of a temporary gain. As I have mentioned previously in entries about Prospect Theory, the pain of losing something is far greater than the joy of getting something. By framing the Fiscal Cliff in the loss domain, the threat of the Fiscal Cliff sounds far greater. If the “increase in payroll taxes” was called “the restoration of Social Security payroll taxes to 2010 levels,” people might find it a bit less alarming.

Perhaps, the greatest threat of the Fiscal Cliff is something that cannot be undone even in the event of an agreement. Brinkmanship harms the country, in that it injects uncertainty into the economy. Businesses need a sense of their future tax liability (and in the case of physicians, revenue) in order to make financial projections and investments. When there is the potential for tax rates to be dramatically changed in fewer than a dozen days, it is becomes hard for businesses to invest in their futures. In doubt, the default choice of most businesses is to stick to the status quo. Businesses, too, have defaults when considering the Fiscal Cliff. As a result, our national uncertainty has the potential to slow down the economy.

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