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CBO chief warns of 'fiscal cliff' and potential recession

Updated at 12:40pm ET:  The director of the Congressional Budget Office, Douglas Elmendorf, said Wednesday that currently planned sharp cuts in spending and increases in taxes at the end of the year would cause “a dramatic reduction in the federal deficit” and “a significant tightening of fiscal policy” which would “probably lead to a recession early next year.”

Analysts refer to this as the “fiscal cliff.”

President Barack Obama and Congress face the question of whether to step back from the fiscal cliff by not allowing the current tax rates to expire at year end and by postponing the spending curbs mandated by last summer’s Budget Control Act.

Before year end, Congress must also decide whether to allow a 27 percent cut in Medicare payments to doctors to take effect – as required by a 1997 budget law -- or whether to put it off, as it has done for the past several years.

“We think that economic growth right now is being held back by the anticipation of this fiscal tightening, both in terms of the possibility of a sharp downturn, but also just uncertainty about what will happen,” Elmendorf told reporters at a CBO briefing.

“The sooner that uncertainty is resolved – especially if it is resolved in the direction of less fiscal tightening next year, then the stronger we think the economy would be” for the rest of this year and next year.

But Elmendorf warned that that alternative would also lead to unpalatable results.

If Congress continues the current tax rates and defers the spending cuts, there would be about two million more workers on the job than if it goes over the fiscal cliff, Elmendorf said. But there will also be higher federal spending, larger deficits, and higher debt over the next several years.

Under that scenario, “rapidly escalating federal debt would increase the risk of a fiscal crisis during which investors would lose confidence in the government’s ability to manage its budget and the government would thereby lose its ability to borrow at affordable rates,” Elmendorf told reporters.

The implication in the CBO’s updated forecast is that whether the next president is Obama or Republican Mitt Romney, he will be narrowly confined by budget and economic conditions created by Congress and Obama in their bargaining between Election Day and New Year’s Eve.

Elmendorf said the key issue facing Congress and the president “is not whether to reduce budget deficits” but when and how to do so. If Congress and the president do not cut the deficit in 2013, Elmendorf said, “They will need to reduce it later. At some point we will need to adopt policies that require people to pay significantly more in taxes, accept substantially less in government benefits and services or both.”

The CBO said in its budget update Wednesday that the government will rack up a $1.1 trillion deficit in the fiscal year which ends on September 30, the fourth year in a row of budget deficits exceeding $1 trillion.

As a percentage of gross domestic product (GDP), the deficit in the current fiscal year will be 7.3 percent.

Debt held by the public will reach its highest level since the Korean War and will be twice the level it was before the financial crisis and the recession.

The CBO report said that federal revenues in the current fiscal year will be about 6 percent higher than last year, while spending will be about 1 percent lower.

But remarkably, revenues in fiscal year 2012 will still be $133 billion less than what the federal government collected in revenues in FY2007, five years ago.

Revenues in 2007 were $2.568 trillion or 18.5 percent of GDP. In FY2012 they will be $2.435 trillion or 15.7 percent of GDP.

Much of the fall in federal revenues is “a natural consequence of the weakness of the economy,” the CBO chief said. “When incomes fall, taxes fall more than proportionately because we have a progressive tax code and people who slip down into lower tax brackets pay a smaller fraction of their income in taxes.”

But he added, “We are a little surprised by how weak tax revenues are, and we don’t know exactly what’s going on there." While CBO has the big-picture revenue numbers, the detailed tax data doesn’t become available from the Internal Revenue Service immediately.

A key variable in the CBO’s forecast is the government’s cost of borrowing, determined by interest rates. “Despite the surge in federal borrowing in recent years, net interest outlays are projected to hold steady at 1.4 percent of GDP through 2015, primarily because interest rates are expected to remain near historic lows for the next few years,” the CBO report said. But it predicted that interest rates will rise after 2015 and cause the government’s interest outlays to nearly double as a percent of GDP.