With the political season heating up, and tax season upon us, we thought it worthwhile drilling into exactly how painful the potential pre-programmed fiscal tightening in 2013 is likely to be. As Credit Suisse notes, "it ain't over til its over" as the suspicion is that a lame duck session of Congress will forestall some of the tightening but until Congress acts, the economy is still technically in a collision course with the largest fiscal hit in modern times.
Credit Suisse: 2013 fiscal logjam
Under current law, fiscal policy in 2013 is pre-programmed to contract sharply absent legislative action. It?s likely that much of the “tightening” will be forestalled in a buzzerbeater lame duck session of Congress. But, to borrow from the great New York Yankee (and New York Mets manager) Yogi Berra: “It ain?t over „til it?s over.” Until Congress acts, (and it?s unlikely it will before the November elections), the economy will still technically be on a collision course with largest fiscal hit in modern times.
We think three groups of provisions are realistically on the table:
1) Extension of the upper-income Bush tax cuts. On this score, we believe the upperincome tax rates, including the top two marginal tax brackets, capital gains tax rates, and dividend tax rates, are the only provisions from the original Bush tax cut program that are realistically in play. Technically, middle income provisions such as extension of the child tax credit, marriage penalty relief, and lower marginal tax brackets, must also be legislatively extended. But allowing a huge and unexpected middle class tax hike to take place on January 1 next year is highly unlikely, in our view. President Obama has said he favors allowing the top two marginal individual rates to move up to where they were in the Clinton years – 36% and 39.6% (from the current 33% and 35%, respectively). He also proposes raising the top long-term capital gains tax rate to 20% (from 15%). And his most recent budget proposes allowing the highest bracket for dividend tax rates to be taxed at ordinary income rates (which would be 39.6%).
2) Lower payroll tax rates and jobless benefit extension. Congress and the president lowered the Social Security payroll tax rate that employees pay by 2 percentage points at the start of 2011, and recently extended that through all of 2012. They also extended unemployment insurance benefits in the same agreement. Like the Bush tax cuts, these are scheduled to lapse as of January 1, 2013.
3) Budget “sequestration”, or the automatic spending cuts scheduled to trigger as part of last year?s Super Committee impasse. Much of this is concentrated in Medicare and defense.
How large is the potential fiscal drag?
Exhibit 3 above shows the change in the cyclically adjusted federal budget balance as calculated by CBO, which captures the change in fiscal policy not associated with changes in the economy (such as faster GDP leading to more tax revenue).
In the Exhibit below, we show three scenarios for fiscal year 2013.
1) A “low” scenario, which assumes the items mentioned above are extended or postponed. This results in fiscal tightening of about -0.9% of GDP. Other polices aside from the ones mentioned above are scheduled to tighten policy moderately next year, such as expiration of some “Recovery Act” stimulus measures, and a rise in Medicare payroll taxes earmarked for the funding of “Obamacare.” Note that fiscal drag of this size is relatively routine, and would not be expected to have a significant impact on the outlook.
2) A “high” scenario, which assumes all three measures we discuss are allowed to kick in. This results in an overall 2.4% fiscal drag during fiscal year 2013, a much more significant hit.
3) A “current law cliff” scenario worth 4% of GDP, which we consider unlikely. This includes not only allowing the three measures we cite above to phase in, but also assumes other items which are routinely enacted every year don?t occur, such as passage of the AMT “patch” and the Medicare “Doc Fix”. It also assumes the middle class portion of the Bush tax cuts are allowed to expire (again, unlikely).
As for what will happen, a lot will depend on which party emerges victorious in November, and how decisive the outcome turns out to be. Our Washington team believes the most likely outcome is something akin to scenario (1), essentially “a kick the can down the road” outcome, as there won?t be enough time or political will to deal with big changes to policy in the lame duck session of Congress.
We would also note that the analysis above is “federal-only.” Another ½ ppt. (more?) of additional fiscal drag is likely from cuts to the budgets of states and localities.