Things That Make You Go Hmmm - Such As The Fiscal Cliff

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From Grant Williams, author of Things That Make You Go Hmm

The effect on the USA of its casually wandering over the Fiscal Cliff will be catastrophic; adding approximately $607bln to the US deficit which in turn would sap anywhere up to 4% (according to the CBO) or possibly even 5% (if Chairman Bernanke—in full-on ‘scare Congress’ mode—is to be believed) from US GDP and send the country crashing into outright recession (or further into recession depending on how things continue to deteriorate in the coming months). “That we cannot have” was the opinion of Erskine Bowles who, along with former Sen. Alan Simpson, devised a debt reduction plan last year to prevent this doomsday scenario.

Bowles was just warming up, however:

“If we do nothing and barrel through this fiscal cliff at the end of the year, we are going to have about $7 trillion hit this country right in the gut,”

Stark.

A look at the statistics published by the Office of Management and Budget (OMB) demonstrates just how swiftly the US deficit has spiralled out of control in recent years. More worrying still— and illustrative of exactly how these organizations work—are the figures for the first full year where no hard data is available i.e. that is solely reliant on the suspension of disbelief government estimates; 2013.

(WARNING: adjective-infested paragraph) As you can see from the table (left), next year (always next year), the OMB is predicting that the US will see a huge 30% reduction in the deficit which will be achieved through the magical combination of a whopping 18% increase in receipts combined with a tiny 0.2% increase in outlays.

Seriously.

“So, how is this all going to play out”, I hear you ask. Well, according to the Washington Post, it breaks down like this:

(WaPo): The payroll tax break expires this December, and the Bush tax cuts expire Jan. 1, meaning that new, higher rates will take effect the following year. Since payroll taxes are deducted from wages every week, the effect there will be immediate, whereas the income tax rate increases only affect income starting in 2013. If employers adjust withholding, the effects could come sooner, but if there are logistical hurdles to that, the economic dent could be delayed.

 

The sequestration cuts will take effect starting in January too, meaning their impact, like the payroll tax cut’s expiration, will be more immediate. The cuts are evenly split, with $27 billion each in 2013 for defense and nondefense spending, plus $12 billion in cuts to Medicare.

The chart above shows the expected effect on the deficit of the various constituents and, as you can see, it’s the Bush tax cuts that have by far the biggest impact, but according to CBO estimates, if just the payroll tax cuts were allowed to expire but the other provisions were extended, the effect on GDP would be a reduction of 2.3%.

The Washington Post also looked at the varying effects on growth of a range of different policies and the picture, I am afraid, does not look pretty, as the chart at the bottom of the page shows.

According to the OMB estimates, any attempt to do something remotely meaningful will result in at least a percentage point reduction in US GDP, which is fine in a world of 3% growth, but today that 1% is not something these guys have to play around with.

In the run-up to December 31, you can guarantee that the issue of the US Fiscal Cliff will replace Europe as the major concern facing the world in general and the US in particular and, if things continue to deteriorate at their current pace, anything that will lead to even a 0.5% cut inGDP will be seen as a  disaster.

Ernst & Young threw their considerably-sized hat into the ring this past week with a helpful survey into the ancillary effects allowing the Bush tax cuts to expire on December 31:

(CNBC): Hiking taxes on upper-income Americans could cost 710,000 jobs, according to a new study.

 

The study, from Ernst & Young and a collection of pro-business groups that includes the National Federation of Independent Business and the U.S. Chamber of Commerce, looked at the impact of raising taxes on capital gains and dividends and hiking the top two individual tax rates to 36 percent and 39.6 percent respectively. It also included the tax hikes for health-care reform.

 

The report found that all of the hikes combined would cause output to fall by 1.3 percent and capital stock and investments to fall by between 1.4 percent to 2.4 percent. It said employment “in the long run” would fall by half a percent, or by about 710,000 jobs. Wages would fall 1.8 percent.

 

“This report finds that these higher marginal tax rates result in a smaller economy, fewer jobs, less investment, and lower wages,” the report stated.

Should the Bush tax cuts be allowed to expire (something President Obama and the Democrats seem hell-bent on ensuring), the top tax rate will climb from 35% to 40.9%, the top tax rate on dividend income will soar to 44.7% from 15% and the tax on capital gains will increase to 24.7% from the current level of 15%.

Last week in the pages of Things That Make You Go Hmmm..... I predicted that François Hollande’s attempts to increase tax revenue in France by increasing taxes on the ’wealthy’ would end up having the opposite effect and I can’t think of any reason why the same wouldn’t be true in the United States. Neither country can afford to get this one wrong. Both seem set to do so.

It’s hard to foresee a set of circumstances under which America’s elected representatives put aside partisan squabbles and knuckle down to make the hard decisions that absolutely need making in order to save their constituents from impending disaster, but what IS certain is that the shift in focusto the Fiscal Cliff we spoke about earlier has already begun as a look at Google searches for the terms ‘euro’ and ‘Fiscal Cliff’ demonstrates. The Washington Post continues to monitor the situation and, in a recent piece, they shed some light on this change in focus in the United States as potential troubles at home becomes more of an issue than those continuing to dog Europe:

(WaPo): For much of the year, economists worried about the impact of the slowdown in Europe on the U.S. economy. Now, analysts say anxiety about the  impact of the fast-approaching fiscal cliff — the series of federal spending cuts and tax hikes set to take effect at the beginning of 2013 if Congress and  the Obama administration do not act — is displacing Europe as the primary threat to the nation’s sputtering economy.

 

Morgan Stanley said this week that concerns about the fiscal cliff are reaching new heights across a wide range of industries. It is already seeing reductions in business orders and hiring, among other areas.

 

“While our analysts are somewhat less worried about the impact of European bank strains,” a Morgan Stanley report said Monday, “the negative impact of fiscal cliff uncertainty is becoming more widespread.” The potential economic impact could smother the flickering recovery and further stifle job creation, analysts warn.

Full report below: