Fiscal Cliff

“I think it is very important to say that if no action were to be taken by the fiscal authorities, the size of the fiscal cliff is such that there is, I think, absolutely no chance that the Federal Reserve could or would have any ability whatsoever to offset that effect on the economy.”-Fed Chairman Ben Bernanke 4/25/12Although the Federal Reserve has become known for its nuanced language and ambiguous answers to questions, investors should recognize the implications of Fed Chairman Ben Bernanke’s recent comments regarding the looming “fiscal cliff.” As if there was not enough to be worried about regarding current economic conditions, the fiscal cliff is already on the minds of investors and policymakers around the world. If nothing is done to address this cliff—essentially a combination of higher taxes and lower spending—the U.S. economy could be pushed to the verge of fiscal tightening unlike anything we have ever seen.The fiscal cliff is the pending result of multiple pieces of legislation that will come to a head at the end of 2012, including the expiration of the Bush tax cuts, the expiration of the 2% payroll tax cut from 2010, the expiration of emergency unemployment benefits, and finally, the sequestration process from the failed Super Committee negotiations that broke down in Fall 2011.The Bush tax cuts, originally set to expire at the end of 2010, were extended in December 2010, ultimately delaying an increase in personal, estate, dividend, and capital gains taxes. If Congress does nothing, a number of changes will occur within the tax code. The chief among them, marginal rates will increase, with the lowest marginal rate rising to 15% from 10%, while rates for the highest income Americans will increase to 39.6% from 35%. In addition to higher rates on personal income, the expiration of the Bush tax cuts will also lead to higher taxes on capital gains (to 20% from 15%) and dividends (up to 39.6% from 15%). Other changes to the tax code will include a return of the Marriage Penalty, expiration of indexing for the alternative minimum tax (AMT), a return to 2001 levels for the estate tax, and an expiration of the expanded child tax credit.¹When President Obama agreed to a two-year extension of the Bush tax cuts, Republicans in turn agreed to a one-year two-percentage-point cut in the payroll tax to 4.2% from 6.2% as well as an extension of unemployment benefits for the long-term unemployed. This agreement was all part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which legislators signed into law in December 2010. Congress then extended the payroll tax cut and the unemployment insurance provisions in February 2012 through the end of 2012.While the revenue side of the fiscal cliff essentially entails the Bush era tax cuts and the 2010 Job Creation Act, spending will decline as a result of the automatic budget sequestration measures that date back to last summer’s debt-ceiling negotiations. Because Congress was unable to agree to real cuts in the budget, the Budget Control Act of 2011 formed a congressional “Super Committee” tasked with reducing federal debt by $1.2 trillion in the form of spending cuts and/or revenue increases over the next decade. With six members from each party making up the committee, their efforts were doomed from the start, and because of their failure, the Act stipulated that $1.2 trillion would automatically be sequestered from defense and nondefense programs over the next 10 years. For 2013, the sequestration works out to $109 billion in across-the-board spending cuts.²The potential squeeze from higher tax rates and lower federal spending could put significant strain on the U.S. economy, which has yet to get itself on a firm footing and establish consistent growth. Estimates of the potential impact of doing nothing vary, but the Congressional Budget Office’s baseline scenario suggests the combined effect of higher taxes ($465 billion) and lower spending (-$28 billion) would be close to $500 billion.³On the tax side of the ledger alone, a recent study by the Tax Policy Center found that the average American household will see their tax bill increase by just over $3,000 in 2013, assuming a complete expiration of all the tax cuts. While higher earners would bear the majority of the increase, all Americans would see their tax bill rise between 3% and 5%.4 The change could strain consumers at every level.Even in years with no major expected changes to spending and tax policies, estimates of future growth vary and are often off the mark. With the fiscal cliff on the horizon, accurately forecasting its impact on the economy is a difficult task. Nevertheless, the Congressional Budget Office (CBO) recently issued a report estimating how the fiscal cliff would affect GDP if nothing is done to address the issue.The CBO’s forecast suggests that GDP will decline in the first half of 2013 by an annualized 1.3%, effectively putting the U.S. economy into recession. Growth is then forecast to resume in the second half, with GDP rising by 2.3% at an annualized rate.5 While individual estimates vary, the general consensus is that the overall hit to GDP will be about three percentage points if policymakers fail to prevent the economy from reaching the cliff.6However, economists disagree about the cliff’s potential effects on growth in the second half of 2012. The CBO and most economists estimate that consumers and businesses will curtail spending leading up to the fiscal cliff by varying degrees. The CBO forecasts real GDP to fall by half a percentage point in the second half of this year in anticipation of higher taxes and lower government expenditures. Other economists, however, have more pessimistic outlooks. Merrill Lynch’s lead U.S. economist Ethan Harris expects annualized growth to drop down to 1.3% (consensus 2.4%) in the third quarter and to further decelerate to just 0.9% annualized (consensus 2.6%) in the fourth quarter.7One important aspect of the expiring tax legislation that we have highlighted is that each piece should have expired at some point in the last two years, but in each specific case, lawmakers reached a last-hour agreement to kick the can down the road and extend the cuts. Based on this trend, it’s certainly possible that lawmakers will once again come together to reach some sort of compromise on some of the cuts to avoid the effects of such a dramatic shift in policy.That view, however, may be overly optimistic. The atmosphere in Washington has never been more divided. During last summer’s debt ceiling negotiations, both parties were unwilling to give ground on anything until the last minute, ultimately only agreeing to delay the agreement! The stalemate was so bad that it prompted Standard & Poor’s Ratings Services to lower its long-term sovereign rating on the United States to ‘AA+’ from ‘AAA’, arguing “that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.” 8While the partisanship in Washington is already at extremes, the upcoming presidential election is likely to only make matters worse. Between now and the election, Republicans are unlikely to make any concessions, as doing so would only boost the image of the President. This takes any chance of a resolution out to November, but difficulties would still remain even at that stage. If President Obama is reelected, one would think that the two sides would be forced to work something out, but given the record in Washington over the last year, nothing is guaranteed.If Mitt Romney is elected in November and Republicans maintain control of the House and possibly even the Senate, legislators could more easily reach an agreement. But under that scenario, Romney would not be inaugurated until January 21, 2013, after the tax cuts expire. In that case, any extension would have to be retroactive, as President Obama would have little incentive to help pass Republican legislation after an election that, to put it mildly, will be nasty.In our view, a worst case scenario—where political brinksmanship leads to no agreement and all the tax cuts expire and the budget sequestration kicks in—is unlikely. The stakes are simply too high for both sides to do nothing.The most likely scenario that we envision is that lawmakers in Washington will do what they do best: put off what needs to be taken care of today, making no meaningful reforms.If policymakers do nothing to taxes or spending, the deficit will continue to build at historical highs. For now, this is unlikely to be a big problem as demand for U.S. debt remains strong. Eventually, though, we will have to face reality, and as the current experience in Europe is showing us, U.S. policymakers face an important choice: Do we sacrifice some short-term gain and make reforms on our own terms, or will we continue to delay the tough decisions and wait until the market forces a much more painful reform?Footnotes1 Jonathan Weisman, “A Year of Tax Code Reckoning,” The New York Times, 2/11/12. http://www.forbes.com/2010/07/22/expiring-bush-cutsaffect- personal-finance-taxes.html2 Congressional Budget Office, “Estimated Impact of Automatic Budget Enforcement Procedures Specified in the Budget Control Act,” 9/12/11. http://www.cbo.gov/sites/default/files/cbofiles/attachments/09-12- BudgetControlAct.pdf3 Congressional Budget Office, “The Budget and Economic Outlook: Fiscal Years 2012 to 2022,” January 2012. http://www.cbo.gov/sites/ default/files/cbofiles/attachments/01-31-2012_Outlook.pdf4 Tax Policy Center, “Table T12-0131,” 4/16/12. http://www.taxpolicycenter. org/numbers/displayatab cfm?Docid=3389&DocTypeID=25 Congressional Budget Office, “Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013,” May 2012. http://www. cbo.gov/sites/default/files/cbofiles/attachments/FiscalRestraint_0.pdf6 Alex Kowalski, “Common Ground Seen Holding U.S. Back From Cliff: Economy,” Bloomberg News, 5/30/12. http://www.bloomberg.com/ news/2012-05-30/u-s-may-avert-plunging-over-fiscal-cliff-in-2013- economy.html7 Ethan Harris, “Fiscal Cliffhanger,” Merrill Lynch Global Research, 5/30/12.8 “United States of America Long-Term Rating Lowered To ‘AA+’ On Political Risks And Rising Debt Burden; Outlook Negative,” Standard & Poor’s, 8/5/11. http://www.washingtonpost.com/wp-srv/politics/ documents/spratingreport_080611.pdfDisclaimerThis market commentary is an advertisement. The commentary concept has been developed by the Conway Wealth Group LLC at Summit Financial Resources, Inc and written by third party contributors edited by the Conway Wealth Group.