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If the deficit goes down too fast, unemployment goes up

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Jared Bernstein/Congressional Budget Office

(Read caption) This chart shows a projection of what would happen to the unemployment rate if the deficit were drastically reduced. According to the CBO, a drastic deficit cut would have a negative impact on the jobless rate.

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The CBO budget update from the other day makes a good, simple point, one ignored by the austerity merchants: if we try to get rid of the deficit too quickly, we will make the jobless situation worse.

The CBO estimates the path of the deficit if all the Bush tax cuts went bye-bye on schedule at the end of this year (current law baseline; the alternative minimum tax would also whack a lot more middle-income people).  Taxes would go up and the deficit would go down.  But the drag to the still-too-weak economy from the reduction in after-tax income would mean less buying power for a lot of families and that would send the unemployment rate back up past 9% in their model by 2013.

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This is very unlikely to happen.  The President plans to let the sun set on the highend tax cuts at the end of this year, while preserving those for households with incomes under $250K.  The highend cuts represent about a quarter of the whole package and they target those who are less income constrained to start with, so I wouldn’t expect them to have anywhere near the effect of the full sunset.

The Bush tax cuts are the main driver of the medium term budget deficit and ultimately, they should all phase out.  But we need to be mindful of the timing.