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What is the Fiscal Cliff and Why is it Important?

“Fiscal Cliff” is a term coined by Federal Reserve Chairman Ben Bernanke to describe the confluence of tax hikes and spending cuts set to begin in January 2013.  The non-partisan Congressional Budget Office (CBO) has projected that as a result of these changes in fiscal policy, over $600 billion will be taken out of the US economy in 2013, of which approximately 60% are tax increases and 40% expenditure reductions.  Over a third of all the changes are tax increases that arise from repeal of the 2001 “Bush Tax Cuts” and an increase (from about 4 million to over 30 million) in the number of taxpayers subject to the Alternative Minimum Tax (AMT), which phases out tax deductions and regular code benefits as income increases. Unlike regular tax rates, AMT rates are not regularly adjusted for inflation. The chart below shows the relative impact of the expiring provisions and changes.

Source: CBO

Other key parts of the pending policy changes are the expiration of Payroll Tax cut, the end of extended federal unemployment benefits, and the first of the across the board “sequestrations” which limit all federal expenditures, including defense, without respect to the relative importance of programs. Taken together, if Congress does not act to prevent these changes, the US economy will have about 5% lower total GDP next year as compared to a continuation of current policies. The expected growth in 2013 in GDP without the pending changes is 1.7% according to the CBO. Unabated, the policy changes would push the US economy into a significant recession with as much as a 3% contraction in 1Q’13 and would be accompanied by a large increase in unemployment.

How Did we Get Here?

The US economy has run record budget deficits of over $1 trillion for each of the past 4 years. As in Europe, constantly rising deficits threaten to eventually overwhelm any government’s ability to repay their debts and are not sustainable. Congress has been unable to forge a bipartisan consensus for achieving stability. Taxes and the role of government lie at the heart of the debate. Generally speaking, Republicans favor spending cuts as a primary means to achieve deficit reduction. Most have publicly pledged to oppose all tax hikes, suggesting that growth through tax cuts will increase revenue. Democrats typically believe tax increases should be part of any bargain to reduce long-term entitlement spending, and have generally supported greater reductions in defense spending.

The Fiscal Cliff is in many ways the culmination of a series of increasingly contentious fiscal showdowns between the two parties over the last few years. A fight to raise the debt ceiling in August 2011 (so the government could continue to pay its bills) resulted in the Budget Control Act (BCA). The BCA required a bipartisan “supercommittee” to identify $1.2 trillion in targeted budget savings over ten years by November 2011 or trigger automatic spending cuts for both defense and non-defense spending in fiscal 2013, a result so onerous to both sides that it was believed to incent agreement. The supercommittee was unable to reach a consensus. The balance of the policy changes in the Fiscal Cliff essentially occurred as an accident of timing, unplanned and unintended, a result of lack of agreement and disagreements.

What’s Going to Happen Now?

The US economy is in the middle of a political game of “chicken”. Almost no one expects any significant attempt to deal with the Fiscal Cliff before the November general election. This uncertainty is widely expected to shave 0.5% from GDP growth in the second half of 2012, as successful businesses postpone capital purchases and hiring additional employees until after some clarity appears.

If action to alter the policy changes does take place, most think it will occur during the Lame Duck session of Congress to begin in late November. Many alternatives could occur as Congress addresses each of the fiscal changes individually. The theory is that by delaying some of the near-term contraction in favor of longer-run deficit reduction, we could get the best of both worlds: no recession in the near term and no debt crisis in the long-term.

It is likely that the largest single change, the Bush era tax cuts, will be allowed to expire. Democrats were reluctant to extend them in 2010, and aren’t anxious to do so again, as they achieve the party’s goal of raising taxes on those who pay taxes rather than broadening the tax base. Republicans perversely want the Bush cuts to expire so that any changes to rates enacted after January can later be claimed to be tax cuts from a higher rate.

The Lame Duck session will probably extend the “temporary” Payroll Tax Cuts,  and an AMT “patch” will likely be passed to keep millions of middle income taxpayers from being subjected to the AMT’s higher rates. The fate of the balance of the Fiscal Cliff policy changes are subject to the general election results. If Mr. Romney wins the presidential race, the Lame Duck session will likely pass legislation to postpone most or all of the changes for about six months to allow the new administration to deal with the issues. If Mr. Obama is re-elected, it is likely that most of the changes will be allowed to take effect. A mild recession will almost certainly ensue, but many believe that taking this tough medicine could set the stage for a more enduring recovery.

How Do We Fix the Problem?

The worst possible outcome from the Fiscal Cliff would be if Congress merely postpones all the 2013 policy changes. The trouble with kicking the can down the road is that you eventually encounter it again. Allowing current law to take effect (walking off the cliff) might pressure legislators enough to enact a comprehensive plan to replace much of the policy changes with a combination of tax reform, entitlement reform, and spending reductions which could phase in gradually and thoughtfully to put the debt on a clear downward path. (see On Leadership). Lower tax rates coupled with the phaseout of the many special interest deductions and credits could unleash GDP growth that would allow the US to grow its way out of deficits and reduce persistently high unemployment.

One Comment

  1. avatar

    david r says:

    Nice post, Dio. I agree that the Bush tax cuts will expire — all of them, because Congress is, well, the same Congress thru year end and because Obama wins the election.

    I think it’s also plausible that the payroll tax holiday will be extended, the AMT and Doc-fix matters dealt with.

    Net/net, I agree totally with you about the likely outcome in 2012. As for 2013, I haven’t a clue. Tax reform seems like a stretch in these partisan times. I think we’ll have a rather large recession — -3% GDP or worse and a slow recovery from that level. As long as tax reform is in the air, corporations won’t invest (very much) and thus employment and tax revenue will suffer. Maybe they can get a corporate tax reform done at least (I doubt it). Most small business is immune to corporate tax rates anyway, so I’m not sure how much it will matter.

    As for investing, there’ll still be a lot of cash on the sidelines in an environment of fiscal uncertainty, monetary blitzkrieg, and international political/financial turmoil.

    The big question is “Does having money in the market at this point make sense or is it grasping for pennies in front of racing steam rollers?” I’m staying on the sidelines, but that’s what you’d expect from the perma-bear.

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