The schizophrenia in US equity markets (and by correlation all risk markets) is nowhere better highlighted than the last 24 hours of 2% swings in the S&P 500 on nothing more than boiler-plate comments from DC. However, as BofAML's Ethan Harris notes, "the year-end fiscal challenges in the US are more like an 'obstacle course' than a 'cliff' - politicians must navigate about 10 major policy decisions before year-end." We continue to expect a messy multistage deal on the cliff - with some wishy-washy partial deal late December and more complete resolution (as it will be called) late Spring. We agree with BoFAML's view that until then, we suggest that investors fade the likely “press fakes” of an imminent deal, and brace for downside volatility. It seems to us that the negotiations remains stuck at square one.
Via BofAML: Cliff Note: Stuck At Square One
In our view, the year-end fiscal challenges in the US are more like an “obstacle course” than a “cliff”—politicians must navigate about 10 major policy decisions before year-end.
More than three weeks after the election and they are still stuck at the first obstacle: the role of taxes in any deficit reduction agreement. What is the hold-up here? Isn’t there an easy deal that focuses on capping deductions? After all, both parties have been talking about this approach as a way to raise taxes on the wealthy without raising tax rates.
We see three reasons why it is proving very hard to overcome this obstacle:
- There is a very big gap in the starting point for negotiations.
- The results of this negotiation could set the tone for future deals.
- On the surface, capping deductions looks like a painless way to raise revenues, but it looks quite ugly upon closer inspection.
As we have been arguing for more than a year, we expect a messy multi-stage deal on the cliff, with a partial deal in late December and a full resolution only in the Spring. During this period, we suggest that investors fade the likely “press fakes” of an imminent deal, and brace for downside volatility.
A big gap
Any deal on the cliff requires an acceptance of the relative role of revenues and outlays in closing the budget gap. The official positions of the major players are miles apart. President Obama has proposed a roughly $4 trillion 10-year deficit reduction plan that is $1.5 trillion (or 40%) tax increases, mainly from allowing the Bush tax cuts to expire for upper income households. His plan has been roundly rejected by Republicans. They argue that most of the spending cuts are not real: his $4 trillion includes almost a trillion in savings that were already agreed to in the first part of the debt-ceiling agreement and almost another trillion in savings from the winding down of the war in Afghanistan. Stripping those items out, the tax increases become three-fourths of a $2 trillion deficit reduction plan.
By contrast, the two main House Republicans, speaker Boehner and Budget Committee chairman Paul Ryan, have suggested that spending cuts should account for all or the vast majority of the cuts. In his negotiations with the President in 2011, Speaker Boehner was apparently close to agreeing in principle on $0.8 trillion in tax increases, or 20% of a $4 trillion dollar plan. However, that deal quickly fell apart once it began to be fleshed out and vetted with the rank and file members in Congress. Moreover, the plan’s reliance on “dynamic scoring”- raising revenues by stimulating growth—has already been strongly rejected by Democrats. Paul Ryan has offered budgets in each of the last two years that include dramatic cuts in spending - including effectively eliminating all of non-defense discretionary spending - but no increase in taxes.
To reach a deal, the two parties must not only bridge a huge gap in terms of the tax share—somewhere between 0% and 75% - they must also agree on the same accounting system.
A big precedent
The outcome in this initial round of negotiations could set the tone for future deals:
- What is the percentage split between revenues and outlays?
- What kinds of revenue increases are acceptable?
- Will the deficit reduction be “dynamically scored”?
- Will the austerity be relatively big or small?
Members of both parties feel that their leaders have given too much ground in the past. Democrats were upset when President Obama agreed to extend all the Bush tax cuts. Republicans are upset about extending the payroll tax cut and extended unemployment benefits. For different reasons, neither party was happy with the outcome of the debt-ceiling debate: for some fiscal conservatives, any debt-ceiling increase was wrong and neither party liked the sequester.
For Democrats, there will never be an easier time to raise upper-income tax rates, since they are set to go up automatically at year-end. This is why many liberal leaning politicians and analysts are arguing that it is better to let all the tax cuts expire—go over the cliff—and then offer to restore tax cuts for just low- and middle-income families. At the same time, if they raise revenues by closing loopholes, it will be harder to do comprehensive tax reform later. On Medicare, there are limits to how much payments to providers can be cut without seriously impairing service. Moreover, as we have seen with the “doc fix”, if the cuts are too big, they simply become part of the annual mini-cliff.
Beauty is skin deep
On the surface, capping deductions seems like an easy compromise. It is less offensive to Republicans than raising tax rates. It is favored by Democrats because the vast majority of the revenue increase would come from the wealthy. And it avoids the politically messy business of identifying which deductions should be limited. Deal done. Let’s move on.
Unfortunately, there is no free lunch in deficit reduction - someone gets hurt. As former budget director Peter Orszag argues, the three most important deductions are mortgage interest, state and local taxes and charity1. Of the three, the most discretionary—or easiest to change—is charity.
How hard is the hit to charities? Americans give about $300 billion (2% of GDP) to charities every year. Most studies suggest at least some loss of funding if the deduction is capped. Indeed, a recent literature review shows “some evidence” that limiting “the tax deductibility of individual charitable contributions would fall entirely on charities themselves: taxpayers would cut their gifts by roughly the increase in their tax bill, reducing charities by an equivalent amount.” In other words, if the government collects an extra $10 billion by capping charitable deductions, charitable giving would drop by about $10 billion, or 3.3%.
By contrast, a rise in tax rates for the wealthy might actually increase charitable giving. On the one hand, higher taxes would have a negative “income effect” on charitable giving, as people would have less income to devote to all kinds of spending. On the other hand, higher tax rates create a “substitution effect” where the cost of each dollar of giving is lower. Thus, if the tax rate is 40% instead of 30%, it costs 60 cents to give a dollar to your favorite charity rather than 70 cents. A cap on deductions creates other challenges. As we have noted before, it tends to hurt people in states that voted for President Obama. Looking at the electoral map, states with high taxes and high home prices—such as New York and California—tended to vote for Obama. Raising upper income taxes through tax rates has a uniform impact on high-income families across the country, while a cap tends to target states with higher-than-average deductions.
The debate over deductions underscores many of our themes around the cliff:
- A long and painful negotiation.
- A multi-step deal into the Spring is much more likely than a quick fix.
- Fade the various press fakes around alleged done deals.
- Don’t be surprised if deals fall apart once the details are vetted.
The markets have vacillated between complacency and concern when it comes to the cliff. After the Fed easing in the fall, the markets seemed to run out of steam as they started to look ahead to year-end. After the election, there was a quick sell-off when the reality of continued split government sank in. The market then rallied Thanksgiving week, when politicians went home for a full week of vacation. And, in the latest week, they are again in worry mode.
There could be a number of critical moments for the markets:
- If politicians remain stuck at square one for too long, then, at some point, the markets will lose patience.
- If some kind of deal can be struck on a combination of tax increases and spending cuts, then the focus will shift to the remainder of the cliff. What is going to happen to the payroll tax cut, unemployment benefits, etc.?
- Once they decide whether to ignore or extend these items, what about the debt ceiling? The Bipartisan Policy Center now estimates that the government will hit the ceiling in December and run out of gimmicks by February.
Finally, all this needs to be bundled into legislation. Vague agreements in principle will have to become specific. They will have to agree on the overall split between tax increases, spending cuts and “can kicking.” If this “sticker shock” phase goes poorly, politicians could accidentally go over the cliff. In sum: Running an obstacle course along a cliff can be dangerous.