The Goverment's "Year End Cliff" Gamble On 2% Of GDP And 10% Of Disposable Income
With mid-term elections a month and a half away, and the expiration of the Bush tax cuts approaching at a rapid pace, the stakes for Obama's dwindling administration on the tax cut extension issue loom. And as Goldman's Alec Phillips demonstrates, the costs of either decision are huge: on one hand, should Obama go ahead and relent to extending all the tax cuts, he will almost guaranteed not be around for a second term due to the avalanche of disappointment in his electorate as he relents on this key promise. On the other hand, should he and the republicans be unable to find a compromise and all tax cuts expire, the impact to the economy could be so vast that America's breezy depression will become a full blown hurricane, possibly worse than anything the nation has ever seen. Phillips' succinct summary of the downside case is as follows: "Letting all of these provisions expire would subtract nearly 10 percentage points from annualized disposable income growth in Q1 2011, which could translate into a nearly 2 percentage point decline in final demand and nearly that large a drag on GDP in the first half of 2011." And it is not just the Bush cuts that are at steak: the year end "cliff" also sees the expiration of the “Making Work Pay” (MWP) payroll tax credit enacted in ARRA, and the relief from the alternative minimum tax (AMT). Yet with such key tax "experts" in the administration as Romer, Orszag and now Summers all gone, Obama will be very much clueless to evaluate the dramatic impact of all these "cliff" developments until it is likely too late. One thing is certain: if a stalemate prevails, GDP for H1 of 2011 will be wildly negative. The summary of the case by case impact can be seen on the chart below.
More from Phillips who succinctly presents the various alternatives before the economy.
The exhibit above illustrates the effect on the annualized level of disposable income from four potential policy scenarios, starting with a baseline assumption of pre-2009 fiscal policy:
1. Our base case. As noted above, our forecast assumes that the middle-income tax cuts and the making work pay credit are extended, along with the patch of the AMT that Congress passes routinely, but that the upper income tax cuts and expanded unemployment benefits expire. This results in a gradual phase-down of the support to disposable income provided by these provisions over the next year or so, from roughly $167bn (annualized) in Q3 2010 to only $7bn by Q3 2011.
2. A legislative stalemate. A significant downside risk to our forecast for early 2011 is the possibility that Congress fails to extend even the broadly supported portion of the tax cuts before they expire at year end. This would occur most likely because of a political impasse in the Senate. This would mean that, in addition to the expirations in our base case, Congress fails to extend even the middle-income tax cuts, the MWP credit, and routine relief from the AMT. For simplicity, the exhibit above shows the effect of a permanent lapse in these provisions, though in all likelihood if the middle-income tax cuts and AMT patch were to lapse it would only be for a couple of months.
3. “All of the above.” The opposite of the stalemate scenario, this assumes that all of the expiring provisions are extended. This could come about if congressional Democrats dropped their opposition to extending the higher-income tax cuts, and Republicans agreed to extend the MWP credit and expanded unemployment benefits (without offsetting savings) in return. While perhaps not the most likely scenario, we nevertheless see some version of this as a reasonable possibility. We suspect some congressional Democrats would be willing to support an extension of the upper income tax cuts if that were the price to be paid to extend unemployment benefits, and at least a few Republicans might find it politically difficult to object to renewing the expanded unemployment benefits while simultaneously supporting an extension of upper income tax cuts that cost roughly the same amount each year.
4. A compromise on upper-income rates. This scenario would involve an extension of all of the 2001/2003 tax cuts, but not the MWP credit or a renewal expanded unemployment benefits. With a limited number of Senate Democrats expressing concerns about the economic effects of letting the upper-income tax cuts expire and little discussion thus far of extending the MWP credit, such an outcome is at least plausible. We include it also to illustrate that the effect on disposable income of extending the upper income tax cuts, but not the tax relief enacted in ARRA, wouldn’t be all that different from our base case.
Beyond the legislative outcome, there are a few other considerations in terms of how the fiscal debate will play out and what effect it may have:
1. Shades of gray on upper income tax cuts. Whether to extend the upper-income tax cuts may not necessarily as black-and-white a proposition as the public debate has made out to be. While the president proposes limiting the extension of tax cuts to incomes under $250,000, Congress could setle on a higher threshold, potentially as high as $1 million. Given that Senate Democrats need to find only a few Republican votes to reach the 60 votes necessary, a few targeted changes to the president’s proposal could be enough to attract the additional support needed. The budget consequences of either threshold would be similar; Joint Tax Committee estimates imply that about 80% of the cost of extending upper-income provisions relates to the treatment of annual income over $1 million.
2. Even a short term lapse could have a sharply negative effect. In the stalemate scenario we outline above, disposable income could decline by nearly 10% at an annual rate in Q1 2011. This assumes that the effect of increased withholding is spread equally over the four quarters, that the increased tax settlements as a result of the expiration of AMT relief are dividend between Q1 and Q2, and that unemployment benefits taper off gradually from Q4 2010 through Q2 2011. Excluding the expiration of AMT relief would cut the effect by half, but this would still result in significant pressure on incomes, and thus potentially on personal consumption. To put this in perspective, even if we assume that consumers passed only one-fourth of the reduction in disposable income that would result from a political stalemate through to spending behavior, the loss of income could still result in a reduction in final demand growth of nearly 2 percentage points (the impact to GDP growth would be slightly smaller, after accounting for the fact that some of this demand would have come from imports and inventories). The upshot is that even a temporary lapse would essentially wipe out most of the modest growth we expect in the first half of 2011.
3. Some taxpayers may look through a temporary lapse, but others may have limited options to smooth consumption. The effect of a lapse on consumers depends on whether they perceive an increase in tax withholding as temporary. On the first, we suspect that many middle- and higher income taxpayers would not respond significantly to a temporary increase in withholding, as they are more likely to have assets and credit to draw on to smooth any temporary cash flow effects. Taxpayers at the lower end of the income spectrum may not have these advantages, and thus may be more susceptible to even a temporary cash flow disruption.
4. The administration has room to maneuver, if it chooses to use it. While only Congress can change the tax laws, the Treasury does have authority over the specifics of how those taxes are collected, including calculating the withholding tables used by employers to deduct taxes from each paycheck. In theory, this could be used to avoid a significant disruption in early 2011. However, before delaying a change in withholding the Treasury would probably need to have some certainty that at least the bulk of the tax cuts were very likely to be extended in order to delay a change in withholding. Otherwise, taxpayers would face an even sharper reduction in income later.
5. Multiple deadlines: November, December, April. Ideally, Congress would enact an extension before it leaves for the midterm election, but this appears very unlikely. Payroll processors have indicated that they would likely to finalize plans for next year’s withholding by November. That said, we suspect that if Congress were to pass an extension of expiring tax provisions by mid-December, the Treasury could process new withholding tables quickly enough to avoid impacting January paychecks. The final and truly binding deadline doesn’t come until April, when tax returns for 2010 are due. In the unlikely event that Congress were to fail to patch the AMT by then, taxpayers in the $150,000 to $500,000 income range would face an unexpected and substantial tax bill.
The process of extending the expiring tax cuts looks likely to begin in earnest this week, with the potential introduction of legislation in the Senate that largely mirrors the president’s proposal. However, enactment of legislation to extend the tax cuts isn’t likely until December. Until then, uncertainty around the fate of the expiring tax cuts as well as other expiring provisions is apt to continue.
For all who are still confused about what all the various tax expiration alternatives represent, here is a great interactive chart summarizing everything under consideration.