A month ago every single bank was delighted when Bernanke proudly announced QEternity. What they did not realize is that by doing so, and by "getting to work" as Chuck Schumer had previously requested of the Chairsatan, Congress suddenly has no impetus to do anything over the fiscal cliff, i.e., to lose face with the electorate by compromising over difficult fiscal issues, because, guess what, Bernanke is on top of it. After all look at the market - no risk is allowed ever again. Because since the Fed is now in charge the market, and of fiscal policy, why bother with protection or Plan B. The banks, however, know better, and know that without hundreds of billions in continued stimulus from D.C., the musical chairs game is about to end and the market will implode. Which is why the warnings of Mutual Assured Destruction (M.A.D.) were only a matter of time. Sure enough, here comes JPM with the first of many official GDP revisions (don't worry - JPM's Mike Feroli will promptly revise everything much higher if a fiscal cliff deal is done... some time in March long after the S&P has tumbled by 20% in a replay of August 2011), in which he sees the fiscal cliff now reducing 2013 GDP growth by 1%, up from the previous estimate of 0.5%, and specifically sees Q1 and Q2 GDP of 1.0% and 1.5%. And it's all downhill from there...
The US fiscal cliff: an update and a downgrade
- The payroll tax holiday looks unlikely to be extended at the end of the year
- The drag on consumer spending could subtract about 0.6%-pt from GDP next year
- We continue to expect most of the Bush-era tax cuts will be extended at year-end
Earlier this year we presented our expectations for 2013 fiscal policy in “US: fiscal cliff notes,” Special Report, April 26, 2012. While many of the views presented there still hold, we are no longer of the belief that the payroll tax holiday will be extended. That change alone is worth over half a percent on GDP growth next year. Overall, we now see cliff-related fiscal issues subtracting about 1%-pt from growth next year, up from our prior assessment of 0.5%-pt. The table at the right summarizes our expectations regarding fiscal cliff outcomes. This note deals exclusively with fiscal cliff-related issues, with a special focus on the payroll tax holiday. There are other important non-cliff fiscal issues, such as declining defense spending, which are not the topic of this note. (We estimate these non-cliff fiscal measures have subtracted about 1%-pt from growth relative to trend over the past year, and will subtract a similar amount in the coming year.)
The holiday is over
As mentioned above, we no longer expect the 2%-pt reduction in payroll tax rates to be extended at year-end—a change that will increase payroll taxes and reduce household disposable income by around $125 billion next year. This tax holiday was initially agreed to in late 2010 as a one-year stimulus measure, partly to replace the expiring Making Work Pay tax credit and partly as a sweetener to get the Democrats in Congress and the White House to go along with a two-year extension of the Bush tax cuts. Last year, as the economy foundered, the Administration pushed for the payroll tax break to be extended another year. After a little resistance, Congressional Republicans agreed to this request.
Our expectation earlier this year was that the economy would remain sluggish and the Administration would once again push for an extension of the payroll tax credit, in order to avoid adding fiscal tightening to an already tepid recovery. The economy has indeed remained sluggish, and yet the Administration has shown little desire to push for an extension of the payroll tax holiday. In this sense, the change in our view wasn’t because of something that happened, but rather what didn’t happen: few in the political establishment came forward to push an extension of this tax break. As such, we are now incoporating a 2%-pt increase in payroll taxes early next year into our forecast.
In addition to the political uncertainty of whether the payroll tax holiday is extended, there is also the economic uncertainty as to how much it has impacted consumer spending. Economic theory suggests that rational consumers will spend very little of a temporary tax windfall. It should do little to affect long-run financial well-being, and consumers instead will use any temporary windfall to increase saving or pay down debt.
The evidence supporting this view is mixed, as some studies have found that the majority of even one-time payments, such as the early 2008 economic stimulus checks, are spent. There are some reasons to think the spending multiplier for the payroll tax cut may be larger than that for the 2008 one-time payments. First, because of the weak economy and stilltight consumer credit conditions, more households may be “liquidity constrained,” i.e., would like to spend more if only they could access saved or borrowed funds. This may be particularly true since the payroll tax cut is proportionally more important for lower- and middle-income households, precisely those more likely to be liquidity constrained. For these households, the entirety of any tax windfall is likely to be spent.
Second, and perhaps more important, is the design of the payroll tax cut. Behavioral economists have found that people are less likely to spend funds that they view as wealth and are more likely to spend income. Highly visible, one-time lumpsum payments like the 2008 stimulus checks are more often viewed as an addition to wealth and thus saved. The steady increment to weekly or biweekly paychecks due to the payroll tax holiday is more likely to be seen as additional income, and is thus more likely to be spent.
Unlike the 2008 stimulus payments, there aren’t many microeconomic studies examining the impact of a payroll tax holiday. In lieu of this, another approach is to look at the behavior of the saving rate when the tax holiday was introduced: all else equal, if the tax holiday had no effect on spending then the saving rate would have increased at the beginning of 2011 and stayed elevated since. If the tax windfall was entirely spent then there would be no impact on the saving rate. As is often the case, all else was not equal: compensation in January 2011 soared—which would tend to put upward pressure on the saving rate—while energy prices rose in the first half of 2011—which would tend to put downward pressure on the saving rate. In any event, the saving rate blipped higher in 1Q11, only to retrace that rise the next quarter. While this evidence is not dispositive, it is consistent with most of the tax windfall being spent, and thus a relatively high multiplier.
In this vein, if we assume a multiplier of around 0.75, then consumer spending next year would be reduced by close to $100 billion, or about 0.6% of GDP. If this adjustment were to occur entirely in 1Q13, then the drag on annualized GDP growth that quarter would be -2.4%-pts, clearly a major restraint. Even if the adjustment is spread out over the first two quarters of the year, which seems more consistent with past experience, the headwind to growth should be noticeable.
Other parts of the cliff
Our expectations regarding other parts of the fiscal cliff remain unchanged—though obviously are held with little confidence given the unsettled situation in Washington. We anticipate that emergency unemployment benefits will be extended, albeit with somewhat reduced generosity. The automatic spending cuts required under the Budget Control Act could play out in a number of ways: our best guess is that some, but not all, of the spending cuts will take place, with the remainder pushed back over the 10-year budget planning horizon. The big kahuna in the fiscal cliff considerations is the Bushera tax cuts. We continue to anticipate that these are extended, though if Obama wins convincingly it will increase the odds that upper-income tax rates revert to higher levels, as may dividend and capital gains tax rates (see “US: the impact of higher dividend and capital gains taxes,” GDW, Oct 5).