Goldman On The Not-So-Good, The Bad, And The Ugly Fiscal Cliff Scenarios That Remain
Even if both the Bush tax cuts and emergency unemployment insurance are extended, the 'sequester' is mostly postponed, and the fresh fiscal drag is confined to the expiration of the payroll tax cut and the new taxes to pay for Obamacare, Goldman estimates suggest that fiscal policy would shave nearly 1.5% from real GDP growth in early 2013. While it seems the 'market' believes that some compromise will be enough to lift the market to new stratospheric heights; we believe, as does Goldman, that the risks are almost exclusively on the downside of this 'not so good' fiscal scenario.
Via Goldman Sachs:
We forecast a renewed slowdown in growth to 1½% in Q1, despite the healing in the private sector and renewed monetary easing.
In addition, the risks are almost exclusively on the downside of this “not so good” fiscal scenario. The probability that the upper-income Bush tax cuts and emergency unemployment legislation will expire, as well as that of a temporary hit from the entire cliff, has clearly risen in recent months. Adding these sources of restraint would take the overall fiscal drag to nearly 2 percentage points in early 2013, and more if the uncertainty effects are large. A sharper slowdown in GDP growth to 1% or less would likely result.
The tail risk is that Congress will fail to agree on any type of resolution for a more extended period, and the economy is hit with both the sequester and much bigger tax increases. While the impact of such a failure—especially those related to confidence and financial conditions—is harder to quantify, just the direct fiscal effect would imply a GDP growth hit of around 4 percentage points in early 2013, and likely a recession.
The Not So Good: Our Base Case
Our base case is that the fiscal cliff is (just barely) resolved by year end, most likely with a temporary extension of the 2001 and 2003 tax cuts, a continued phase down of Emergency Unemployment Compensation (EUC) and a temporary delay of the spending cuts under sequestration. Under our central assumption we assume that the $120bn payroll tax cut expires at year end and that new taxes that were enacted as part of the Affordable Care Act (ACA) are implemented on schedule.
The Bad: A Temporary Lapse; Upper Income Tax Cuts and Jobless Benefits Also Expire
A second possible scenario is that lawmakers will allow the upper income portions of the 2001/2003 tax cuts (defined as income over $250,000) and EUC to expire, in addition to the fiscal restraint in our base case. While it is possible that Congress could vote prior to year end to “decouple” the upper income tax cuts from the rest of the Bush tax cuts, it is more likely in our view that this would happen after year end due to fundamental disagreement between the political parties.
The White House has indicated on several occasions that the President would veto a further extension of the upper-income provisions, while Congressional Republicans have indicated they would not support decoupling them from the rest of the 2001/2003 tax cuts.
While there are possible compromises between these two positions—raising rates only on income over $1 million, for instance—reaching an agreement on this in the few weeks lawmakers will have before year end seems to us to be a significant political challenge. A deal on this question could also be made easier once taxes have risen, since lawmakers could claim that setting tax rates and/or revenue levels higher than 2012 would nevertheless constitute a “tax cut” compared with the policies that would be in effect in January 2013.
We assume that if the upper income tax cuts are allowed to expire, emergency jobless benefits would expire as well. In light of the continued phase down in eligibility since the start of the year, the expiration would not have as great of an effect as it would have had a couple of years ago, but would still represent an incremental drag on growth compared with our base case.
Such a scenario would likely result in growth below our forecast for 2013, particularly in the first half of the year, especially if some of the 2001/2003 tax cuts and EUC were allowed to expire. That said, there are at least three reasons to think that while negative, a temporary lapse would not hit growth by nearly as much as implied in the worst-case scenario:
- A lapse would probably be reversed quickly. It is likely that if Congress were to fail to address this issue before the end of the year, lawmakers would return inJanuary and reach an agreement fairly quickly. The debt limit, which Congress must raise no later than early March according to our projections, might serve as a deadline for action on the fiscal cliff if public pressure hasn’t already forced an agreement. If, for example, an agreement were reached in January, we assume it would reinstate most policies retroactively, meaning that much of the effect would be reversed before the end of the quarter, reducing the overall economic effect.
- The Administration may have some flexibility in implementing tax hikes and spending cuts. Beyond the likelihood that Congress would revisit the fiscal cliff fairly quickly if these provisions were to expire, there is a possibility that the Treasury and other federal agencies could delay implementation of the scheduled fiscal tightening if the lapse was expected to be temporary. On the tax side, the Treasury may have some flexibility in determining tax withholding. It is possible that if Congress were expected to extend the tax cuts retroactively, the Treasury could maintain tax withholding at current levels in anticipation of an agreement. This would cushion the effect of a short lapse, but would be ineffective in addressing a prolonged lapse in the 2001/2003 tax cuts. It is possible that the phase-in of the sequester could also be made more gradual if the cuts were expected to be reversed early in 2013.
- Uncertainty effects would depend on why a lapse occurs. It is difficult to assess how consumers or businesses would react in the face of a temporary tax increase. If a retroactive extension of most or all of the policies is widely expected, it is quite possible that some consumers would “look through” a temporary reduction in after-tax income. That said, we suspect that if Congress fails to address the fiscal cliff at year-end it will be due to a political stalemate, so there could be at least short-term uncertainty effects.
The Ugly: Congress Fails to Address the Fiscal Cliff
In light of the recent fiscal debates and the disagreements between the political parties, one cannot completely rule out the possibility that lawmakers simply fail to reach agreement on the fiscal cliff due to continued disagreement over the most controversial tax and spending issues, which hold up agreement on other less controversial provisions.
That said, we view this as a low probability event not only because lawmakers will ultimately want to avoid inducing a recession, but also because they are apt to respond to the inevitable pressure to address the situation that would come from the public, businesses, financial markets. Moreover, a broad swath of lawmakers support averting at least half of the policy changes set to take effect at year end, so even in the worst-case scenario it is unlikely that Congress and the President would allow a permanent lapse in the full range of provisions that make up the fiscal cliff.
Updating our Estimates of Fiscal Drag
We have updated our estimates of the expected effect of fiscal policy on growth. We have incorporated the most recent estimates from the Congressional Budget Office and Joint Tax Committee on the budgetary effects of each of the various components of the fiscal cliff (exhibit 1). These are very similar to prior projections, though the estimated revenue effect of the 2001/2003 tax cuts has grown slightly from estimates earlier this year, while the projected spending cut due to the sequester has declined slightly (Exhibit 1). We have also included “second round” effects on growth in subsequent quarters that result from the direct hit to growth due to fiscal changes.
Estimates of the three scenarios noted above are shown in Exhibit 2. Under the baseline “not so good” scenario, fiscal policy would shave nearly 1½ percentage points from real GDP growth in early 2013, compared with ¾ points in 2012. In this case, we expect a renewed moderate GDP growth slowdown to a 1½% pace in early 2013.
Under the alternative “bad” scenario, the fiscal drag would rise to nearly 2 percentage points in early 2013. This bigger hit, combined with the possible greater uncertainty if an agreement proves elusive for a few weeks in early 2013, would probably cause a sharper slowdown in GDP growth to 1% or less.
Finally, there is the tail risk scenario that Congress fails to agree on any type of resolution for a more extended period, and the economy is hit with both the sequester and much bigger tax increases. While the impact of such a failure—especially those related to confidence and financial conditions—are harder to quantify, just the direct fiscal impact would imply a GDP growth hit of around 4 percentage points in early 2013, and likely a recession.
There is inherent uncertainty in these estimates due not only to unpredictability of the political debate on the fiscal cliff, but also to uncertainty surrounding the effect on growth of different types of fiscal policy changes. Exhibit 3 shows the range of multipliers estimated by the Congressional Budget Office (CBO) for several types of fiscal policy changes. Our own multiplier estimates are in the upper half of the ranges provided by the CBO. We believe that this is reasonable. Recent economic research has demonstrated that fiscal multipliers are relatively large in a depressed economy that is operating at the effective lower bound for nominal short-term interest rates. For example, some studies have used cross-state variation in spending and taxes to isolate the impacts in a situation in which there is no monetary policy offset, and they have generally found rather large multipliers. Our own work using cross-country data and “shutting down” the monetary policy offset to fiscal contraction via statistical analysis has come to similar conclusions.
In addition to these quantifiable drags, we would also expect a negative impact on growth via deterioration in market, business, and consumer confidence. Some of this impact might already occur before the end of the year, as the uncertainty builds. While such an “uncertainty shock” could reverse quickly, providing a large amount of support in a short period of time if a deal is struck, the ride for both the financial markets and the real economy would undoubtedly be rocky.
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