* Cost of social safety-net programs could rise
* Agencies would face paying penalties to suppliers
* Tax cheats might prosper with reduction in oversight
By Andy Sullivan
WASHINGTON, Feb 28 (Reuters) - On paper, there's one thing to like about the ugly spending cuts due to kick in on Friday: $85 billion in budget savings at a time when Washington continues to bleed red ink.
In reality, the so-called "sequester" is likely to yield less than half that much in the short term.
In part, that has to do with the complex way the government handles its money. But it also reflects the probability that the spending cuts will hurt the economy, which in turn will lower tax revenue and drive up the costs of social safety-net programs like unemployment insurance.
On top of that, federal agencies - especially the Pentagon - will have to pay penalties to suppliers if the sequester forced them to cancel contracts.
Add it up, and the actual savings could be a lot less than budget hawks envision.
"There is a possibility that we'd save virtually nothing in outlays," said Steve Bell, a former Republican congressional aide now with the Bipartisan Policy Center, a Washington think tank.
Even a relatively small decline in spending would be magnified over the coming years as it would reduce debt-servicing costs.
But the sequester would do little to restrain federal debt over the long term because it fails to tackle health costs, which are projected to balloon as the population ages. If the sequester were not to take effect, federal debt would equal the size of the economy by 2031, according to the Bipartisan Policy Center.
With the sequester in place, it will hit that dubious milestone in 2033.
The sequester was not supposed to happen. Republicans and Democrats in 2011 set up the deep cuts to military and domestic spending as a worst-case scenario that would force them to reach tough decisions on taxes and spending in order to set U.S. finances on a sustainable course.
But they have been unable to reach an agreement. Absent a last-minute deal, spending cuts of about 13 percent for defense programs and 9 percent for domestic programs will kick in just before Friday night.
CRUNCHING THE NUMBERS
The $85 billion cut to budget authority amounts to about 2.4 percent of the $3.6 trillion the U.S. government is expected to spend in the fiscal year that ends on Sept. 30.
The actual amount of savings is much less - $43 billion in the current fiscal year, according to the Congressional Budget Office. That's because federal agencies don't spend all of the money they are allocated in any given fiscal year. A $1 billion aircraft carrier, for example, may take years to build.
Even at that lower level, the effects are likely to ripple across the world's largest economy in a way that will work against deficit-reduction efforts.
The nonpartisan CBO estimates gross domestic product will grow by 1.4 percent this year, compared to 2.0 percent if the sequester was not in place. The Bipartisan Policy Center estimates the sequester will lead to 1 million lost jobs in 2013 and 2014.
Slower economic growth means the government will collect less tax revenue as businesses and workers earn less than they would otherwise - a fact that Federal Reserve Chairman Ben Bernanke highlighted in congressional testimony on Wednesday.
"Besides having adverse effects on jobs and incomes, a slower recovery would lead to less actual deficit reduction in the short run for any given set of fiscal actions," Bernanke told the House of Representatives Financial Services Committee.
The CBO estimated last year that a 0.1-percentage-point drop in GDP growth translates into $1 billion less in tax revenue. That would indicate the government will take in $6 billion less this year if the sequester takes hold.
The sequester could impact government revenue in other ways as well. The Internal Revenue Service has warned that it could be forced to scale back its enforcement, letting more tax cheats get away.
The government could lose more money to health-care fraud as well if the administrators of the Medicare and Medicaid health plans are forced to scale back their reward programs for whistle blowers.
Slower economic growth also forces the government to spend more on food stamps, unemployment aid and other social programs.
The budget impact of these "automatic stabilizers" - so called because they kick in without requiring new government action - can be dramatic. According to CBO, they added $367 billion to the deficit in the 2011 fiscal year, while they reduced the deficit by $44 billion in fiscal 2007, before the recession hit.
CBO projected last year that these social programs would widen budget deficits further because of the impact of the sequester and steep tax increases that were due to take effect on Jan. 1.
Most of those tax hikes have been averted, but budget experts said the sequester will still drive up their costs.
"It seems pretty clear that some of the deficit reduction you achieve by allowing sequester to occur would be dissipated," said Joe Minarik, a former budget official under President Bill Clinton. (Reporting by Andy Sullivan; Editing by Xavier Briand)