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Sequestration: The Truth Behind The Spending Cuts

 February 28, 2013 11:03 AM

(By Mani) Under current law, beginning on March 1 the sweeping set of spending cuts, known as sequestration, are set to go into effect. The spending cuts will have some slight negative consequences on economic growth in the near term, but likely will support higher levels of growth longer term.

Within the D.C. beltway, one of the most complicated of public policy topics is that of the federal budget. In general, the federal budget can be separated into two constituent components: budget authority and budget outlays.

Budget authority, as its name implies, is the authorization to spend federal funds immediately or in a future period. Budget outlays are actual spending by the federal government. Thus, budget outlays are the key factor in determining the impact on GDP from cuts to federal spending.

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According to the Congressional Budget Office (CBO), outlays this federal fiscal year, ending in September 2013, will be reduced under current law by $44 billion, not the widely cited $85 billion in budget authority. In other words, the actual budget outlays are lesser than the authority.

The majority of the negative effects on outlays, and thus GDP growth, will occur beginning in 2014 and become more severe in 2015 and beyond.

"We expect GDP growth on a year-over-year basis to increase 1.7 percent in 2013 and rise 2.1 percent in 2014. We expect both direct and indirect effects on GDP as a result of the scheduled cuts," Wells Fargo economist John Silvia wrote in a note to clients.

Federal government, as well as state and local government spending will be reduced as the federal government cuts outlays and grants to other levels of government. The indirect effects include reduced personal consumption as furloughs and civilian federal personal salaries reductions weigh on personal income growth. Meanwhile, job growth would be slow due to reduced government hiring.

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"Even with the negative effects cited above, we do not expect the budget sequestration process to derail the modest pickup in GDP over the next couple of years," Silvia said.

While the effects of budget sequestration may not be severe on headline GDP growth, the magnitude of the impact will vary across the country. The more negative effects of the federal budget cuts beginning in 2014 and beyond could serve as a stronger headwind to growth.

But, again, the real private final demand to domestic purchasers, a measure of underlying demand in the economy, should continue its steady improvement.

To arrive at a last-minute deal to avoid the sequestration, there will be a meeting at the White House between President Barack Obama and congressional leaders on Friday, but expectations are low.

The annual sequestration process was brought into the public spotlight back in 2011 when the Budget Control Act of 2011 established automatic budget cuts, a sequestration of spending authority if a designated deficit reduction committee failed to arrive at a long-term deficit reduction plan.

In December of last year, the nation climbed over the "fiscal cliff," and Congress delayed the implementation of the sequestration process until March 1 and reduced the amount of budget cuts to be implemented this fiscal year to around $85 billion.

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