Investors remain convinced, it would seem, that the fiscal cliff will not happen because our great-and-good politicians in Washington know full-well that the economic repercussions will be too great. Even though Ben's foot is to the floor, he has stated that monetary policy will be unable to offset the negative economic impact of the tax hikes and spending cuts. The prospect of agreement among a deeply polarized politik and just as Goldman expects, we worry that the S&P 500 will fall sharply following the election once investors finally recognize the serious possibility that the 'fiscal-cliff-problem' will not be solved in a smooth manner. In order to clarify that thinking, Bloomberg Brief has provided 12 charts on the timelines, impact, uncertainty, and possibilities surrounding this most obvious of risk events.
The so-called ‘fiscal cliff,’ the confluence of $607 billion in expiring tax and expenditure policies set to take effect at the end of 2012, poses a significant risk to the U.S. economic outlook.
Unless lawmakers reach a compromise to extend some or all of the temporary tax cuts and postpone mandatory spending cuts, the hit to the economy would translate into about 4 percent of gross domestic product.
There will probably be little movement to address the economic consequences of the fiscal cliff until after the November U.S. presidential election. This will leave policy makers the one-month lame duck session of the 112th Congress between Nov. 13 and the currently scheduled day of adjournment on Dec. 14 to reach a decision before the scheduled tax increases and mandatory spending cuts will take effect Jan. 1.
Given political polarization, these issues may well not be addressed until the start of the 113th Congress on Jan. 3, 2013.
Growth And Austerity: This is not the first experience that the federal government has had with periods of austerity. During the Reagan, George Herbert Walker Bush and Clinton administrations, periods of bi-partisan fiscal restraint were seen. Solid growth in the Reagan and Clinton eras contrast with slower growth and an eventual slide into recession during Bush the elder administrations. The major difference between those eras and our current period is historically slow growth occurring at the same time as high political polarization. These conditions are not conducive to a grand bargain to put the nation’s fiscal path on a more sustainable footing and avoid a likely recession in 2013.
The burden of adjustment caused by the significant fiscal restraint that would take place next year would be spread around the public and private sector. The end of emergency unemployment benefits alone accounts for $40 billion in reduced government spending. The Congressional Budget Office estimates that each dollar of unemployment insurance generates $1.55 in additional economic activity.
Defense Spending: automatic sequestration may result in about $55 billion in defense and non-defense accounts from the Pentagon that account for roughly half of the $110 billion resulting from the Budget Control Act of 2011. Based on current statutes, only a new law that terminates automatic defense cuts can prevent sequestration. One result of major cuts in defense spending would likely be the loss of tens of thousands of defense contractor-related jobs. Many of these jobs are held by middle and upper middle class income earners critical to supporting current levels of household spending.
Taxes & Spending
The policies that put the fiscal path on a sustainable footing will likely involve a mixture of spending cuts and tax increases over the next decade or two. In any debate, the most contentious portion of it will revolve around how the burden of adjustment is distributed throughout the economy while supporting growth and reducing unemployment.
Marginal Rates Pre- and Post-Cliff: The sunset of the Bush tax cuts and the expiration of the Obama tax holiday, as well as a variety of tax hikes and spending cuts, will boost marginal tax rates across the board, collapsing the six tax brackets into five. Using a conservative multiplier, the end of the $220 billion Bush tax cuts would result in a reduction in consumer spending of roughly $200 billion or 1.3 percent of GDP. The end of the Obama tax holiday would produce a $95 billion hit to household spending, subtracting 0.6 percent from GDP.
Increased taxes on corporations may not be a good way to encourage growth. While taxes on individuals have come down substantially over the past 30 years, that is not the case when it comes to U.S. statutory corporate tax rates. The 2012 combined government corporate tax rate in the U.S. is 39 percent, trailed by Japan at 38 percent, France at 34.4 percent and Germany at 30.2 percent.
Federal Government Revenues and Outlays: Debt-to-GDP levels will need to be stabilized at near 100 percent, whether through a decline in outlays, by finding ways to increase revenues without slowing growth, or some combination of the two. Based on the most recent CBO study, tax receipts are projected to increase 41 percent between 2011 and 2017, while a 21 percent rise in spending is forecast.
Discretionary Spending: Without a consensus among lawmakers on how to reform entitlement spending or enact comprehensive tax reform, discretionary spending will bear roughly half the burden of the automatic sequestration set to take place due to the Budget Control Act of 2011.
Politics And Policy
The fiscal cliff is set to occur within 60 days of what is shaping up to be a rancorous national election. Given the depth of the ‘Great Recession’ and measures taken to prevent it from becoming a depression, the importance of politics and policy has increased in relevance for investors.
Competing Visions: Fundamental policy disagreements among politicians regarding the size and scope of government is the primary cause behind the unusual confluence of so many tax and spending items coming to a head at one time. Using the CBO’s baseline forecast as a benchmark, federal spending as a percentage of GDP is likely to increase from 24.1 percent in 2011 to 24.4 in 2022.
Investors Troubled by Policy Uncertainty: Investors and some economists have pointed to a lack of clarity regarding the future path of taxes to support current levels of public expenditures, and the impact of stepped-up regulatory activity on overall business conditions. An index of policy uncertainty and its impact on output, investment and employment developed at Stanford University and the University of Chicago indicates a clear lack of direction in addressing persistent deficits. The level of debt likely foreshadows slower growth and subdued employment conditions ahead.
33 Senate Seats in Play: Based on an estimate by Roll Call magazine, of the 33 seats up for grabs, seven are at risk during the upcoming election, six held by Democrats and one held by Republicans. Presently, the Senate is comprised of 51 Democrats, 47 Republicans and two Independents.
28 House Seats in Play: Roll Call indicates that there are 28 House races that currently rate as a toss-up. There are two open seats and one new seat in Arizona’s 9th district due to the shift in population that has seen Congressional seats migrate from the northeast to the south and west. Presently the House is comprised of 192 Democrats, 240 Republicans and three vacancies.
"If the fiscal cliff isn’t addressed, as I’ve said, I don’t think our tools are strong enough to offset the effects of a major fiscal shock, so we’d have to think about what to do in that contingency.”
— Ben S. Bernanke, Federal Reserve chairman
Source: Bloomberg Briefs