By Brian Horrigan
August 17, 2012
The following note reflects the views of Loomis Saylesâ Chief Economist Brian Horrigan. They do not necessarily represent the views of the firm. Given the volatile nature of capital markets, views are subject to change rapidly.
In the famous 1955 movie Rebel Without a Cause, troubled high school student Jim Stark (played by James Dean) winds up playing a game of chicken with his classmates. The game is played as two teenage boys drive stolen cars toward a cliff. The first one to jump out of his car âchickens out,â losing the game. Jim tark jumps first, but his competitor gets his jacket stuck on the gear shift, is unable to jump out of the car and ends up going over the cliff to his doom. I cannot say that he won that game.
The US economy is at risk of driving, so to speak, over a âfiscal cliff â starting January 1, 2013, an event that threatens to wreck the economy. The fiscal cliff got its name because under current law, there will be a massive and rapid tightening of fiscal policy in January unless Congress and the president agree to change the law before then. There are fewer than five months to avoid going over this cliff.
It is an election year, and Democrats and Republicans are locked in a battle royale as the Democrats aim to take back the House of Representatives while the Republicans aim to take back the Senate and White House. Each party has very particular and different proposals about what kind of adjustments should be made, or not made, to taxes and spending. Neither party wants the US to go over the fiscal cliff, but electionyear politics are not congenial to the type of political compromise necessary for a divided government to change the law. And so the political parties are acting much like the teenage boys in the movie, determined to be brave and strong and insistent that the other party make the concessions necessary to avoid going off the cliff. It seems unfortunate that current US politics resembles a dangerous game played by juvenile delinquents, but I believe that is what we have reached. In politics, as in the movie, the game might not end well.
If the US economy goes over the fiscal cliff, the impact could be huge. The economy would probably slip back into recession, and with the unemployment rate currently close to 8%, the US can little afford another significant rise in unemployment. Going over the cliff could have profoundâand not entirely predictableâ consequences for the stock market, Treasury and corporate bond yields, commodity prices, and the US dollar.
Below, I give the details about policies that contributed to the current predicament, what exactly the fiscal cliff is, what going off the fiscal cliff could do, and how the government may address the risk. To quote an old Russian proverb, âWe should hope for the best but prepare for the worst.â
HOW DID WE GET HERE?
The largest part of the fiscal cliff is the so-called Bush tax cuts, which were created by two pieces of legislation, called the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). These acts cut income tax rates, created new tax credits, raised certain tax exemptions, expanded depreciation allowances, restricted the Alternative Minimum Tax (AMT), and reduced estate taxes.
EGTRRA was signed into law by President Bush on June 7, 2001, as a fiscal response to the âtech wreckâ that began in 2000 and pushed the US economy into recession in early 2001. It was a sweeping piece of tax legislation that lowered income tax rates, revised exemptions and credits to reduce the âmarriage penalty,â phased out the estate tax, and extended and simplified retirement and savings plans.
The most notable feature of the tax law was a multi-year reduction in tax rates for each income tax bracket. In particular, by 2006 the 28% bracket would be lowered to 25%, the 31% bracket would be lowered to 28%, the 36% bracket would be lowered to 33%, and the 39.6% bracket would be lowered to 35%. The 15% tax bracket was left alone, but a new 10% bracket was created for low-income tax filers, and the 15% bracketâs lower-income threshold was indexed to the new 10% bracket. To address the so-called marriage penalty in the income tax, EGTRRA raised the standard deduction for married couples filing jointly. Additionally, EGTRRA increased the per-child tax credit and the tax credit for spending on dependent child care, and phased out limits on itemized deductions and personal exemptions for higher-income taxpayers. The law expanded and simplified the rules for retirement plans (such as Individual Retirement Accounts) and for educational savings accounts (called 529 plans). Finally, the law gradually reduced the estate tax, eliminating it entirely in 2010.
It may seem odd that EGTRRA was set to expire in its entirety at the end of 2010, but Congressional budgetary rules impose a time limit on tax changes.
The recession of 2001 was one of the shortest and mildest in US history, but the recovery was relatively sluggish. The Federal Reserve Board (the Fed) eased to promote a better recovery, pushing its federal funds rate down to 1.00%, which helped start the housing boom. President Bush also requested another round of tax stimulus to boost the recovery, and Congress delivered. JGTRRA was signed into law by the president on May 28, 2003.
JGTRRA accelerated the gradual income rate reductions and the tax credit increases passed in EGTRRA so that instead of taking full effect in 2006, they took full effect immediately and were made retroactive to January 2003. In addition, the threshold at which the AMT applied was also increased. Finally, to reduce the double-taxation of corporate equity income, the tax treatment of capital gains and dividends was changed. Corporate income is taxed twice under current law, once because of the corporate income tax, and the second time because dividends and capital gains are taxed through the personal income tax. By contrast, the interest on corporate bonds is not doubly taxed because although it is taxed at the personal level, it is not taxed at the corporate level because interest paid is deducted in the calculation of corporate income. Many economists believe the double-taxation of corporate equity income has deleterious economic effects, including encouraging excessive corporate leverage, discouraging corporate investment, discouraging the payment of dividends, and inhibiting the efficient use of the corporate form of organization. The maximum tax on long-term capital gains was cut from 20% to 15%. âQualified dividendsâ (1) were no longer taxed as ordinary income; their maximum tax rate was also cut to 15%. The provisions of JGTRRA were scheduled to expire at the end of 2010 along with the provisions of EGTRRA.
Whether the Bush tax cuts were good or bad is a matter of opinion, but in the current election season, each political partyâs stance concerning their future is clear. For the most part, the Republicans believe they all should be extended, while President Obama campaigned in 2008 for repealing some, but not all, of the cutsâa view he still supports.
The AMT was created by the Tax Reform Act of 1969 in response to a discovery that 155 high-income households had paid no income tax through the aggressive use of tax benefits. The AMT was designed to require that everyone with a high income pay some income tax by capping the use of tax benefits. The AMT has been modified numerous times since 1969, but one important feature remains: the exemption amounts are not indexed for inflation. The result is that the AMT captures an increasing share of American households, many of whom are not high income. Moreover, the interaction of the AMT and the regular income tax is such that the AMT, if unmodified, would have offset some of the Bush tax cuts. Rather than make a permanent reform of the AMT, in recent years Congress has made a series of short-term âpatchesâ to the AMT to limit its reach, patches that reduced federal revenue. The most recent AMT patch expired at the end of 2011, but Congress is considering renewing the patch for 2012. If it does, the new patch would expire at the end of 2012. In recent years, slightly over 4 million tax returns were subject to the AMT. If Congress does not continue its patches for the AMT, the Congressional Budget Office estimates that in fewer than 10 years, over 40 million tax returns would be subject to the AMT.
The US faced an early version of fiscal cliff at the end of 2010, when all of the Bush tax cuts and the AMT patch were scheduled to expire. Many thought the economic recovery was weak and feared that the end of the Bush tax cuts would impose more fiscal austerity than the fragile recovery could withstand. After the elections of November 2010, President Obama asked Congress to extend the Bush tax cuts for the middle- and lower-income tax brackets but to allow the tax cuts on the high-income tax brackets to expire as scheduled, a policy he advocated during his campaign. Congress declined to implement President Obamaâs proposals.
Subsequently, the administration and Congress worked out a compromise. In December 2010, Congress passed and President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. That law extended all of the Bush tax cuts (including various tax credits, deductions and exemptions) through the end of 2012, renewed the AMT patch and extended emergency unemployment benefits through 2011. To boost household incomes further, the law also delivered for 2011 a two-percentage point reduction in the employee portion of the Social Security payroll tax (from 6.2% to 4.2% for paycheck employees and from 12.4% to 10.4% for the self-employed). To boost investment, qualified business capital spending was given more generous tax depreciation allowances; in particular, such spending was 100% tax deductible through the end of 2011 and 50% tax deductible through the end of 2012. Finally, the federal estate tax, which was eliminated for 2010, was due to return to its Clinton-era levels in 2011. The law allowed the estate tax to return but established a $5 million exemption and a maximum tax rate of 35% through the end of 2012.
WHAT IS THE FISCAL CLIFF?
The vast array of tax features scheduled to expire at the end of 2012 would generate the fiscal cliff. Below, I outline the various elements of the fiscal cliff and how much money they would cost. These estimates are derived from analysis by the Congressional Budget Office (CBO) (2). I warn that these estimates are imprecise, but I think they give the right flavor to the issue.
Income Taxes and AMT
While President Obama has been highly critical of the Bush income tax cuts, he has nonetheless asked repeatedly that Congress renew most of them. In particular, he has asked that the Bush tax cuts for higherincome taxpayers expire at the end of 2012 but that cuts for everyone else be renewed indefinitely. The Republican opposition prefers to renew all of the Bush tax cuts. As they position their parties for the November elections, Congressional leaders in both parties have stated that they will not yield on their respective positions. If nothing is done, all of the Bush income tax cuts will expire at the end of 2012, even though that is not the preferred policy of either party.
The latest patch for the AMT expired at the end of 2011. It is widely expected that Congress will renew the patch for 2012, but nothing has been done so far concerning 2013. So we consider the expiration of the AMT patch in January 2013 part of the fiscal cliff.
If all of the Bush income tax cuts and the AMT patch expire at the end of 2012 as scheduled, income taxes would rise by $265 billion in 2013.
It could get worse. If Congress fails to renew the AMT patch for 2012 or 2013, not only will millions of taxpayers be liable for higher taxes for the 2013 tax year, but come April 2013, millions will have to pay higher taxes for their 2012 income. It would be a double-hit of higher tax withholdings for 2013 and higher tax payments in April 2013 for 2012 income.
Still worried about the fragility of the recovery, in September 2011 President Obama asked Congress to double down on the payroll tax holiday, requesting not only that the two-percentage-point employee payroll tax holiday be extended through the end of 2012 but also that the employer portion of the payroll tax also be cut by two percentage points. In addition, he asked that emergency unemployment benefits be extended through the end of 2012. After much negotiation, in February 2012, Congress passed the Middle Class TaxRelief and Job Creation Act of 2012, which extended the cut in the payroll tax for employees through the end of 2012 but did not expand the tax cut to include employers.
If the payroll tax holiday expires at the end of 2012, payroll taxes would rise by $127 billion in 2013.
Other Tax Provisions and Depreciation Benefits
A host of small tax credits and exemptions are either due to expire at the end of 2012 or expired at the end of 2011 but have lagged effects on tax revenues. Most of them are small; the largest tax feature is partial expensing of capital spending, an investment stimulus granted through more generous depreciation provisions. If these tax features are allowed to expire at the end of 2012, taxes (mostly on business) would rise by $87 billion in 2013.
Federal estate taxation changes so much, it is hard to keep track. The estate tax disappeared in 2010 only to reappear in 2011. If current law is not changed, in 2013, it will revert to its form from 2000. The maximum tax rate would go up from its current 35% to 55%, while the exemption amount would fall from $5 million to $1 million. The result would be an estimated increase in tax liabilities of about $30 billion for 2013, nearly all of which would be paid in 2014.
In 2010, Congress passed and President Obama signed into law the Patient Protection and Affordable Care Act, or ACA for short, which has been nicknamed âObamaCare.â This long and complex law was designed to extend medical insurance to the uninsured, overhaul medical sector regulations and control medical costs. To fund the program, a series of tax increases is scheduled, starting in 2013.
Currently, the Hospital Insurance (Medicare) payroll tax is a flat 2.9% on all employee wage and salary income. For Medicare, unlike Social Security, there is no cap on taxable payroll income. The tax is shared equally by employers and employees, who each pay 1.45% of payroll. The self-employed pay a full 2.9% on their earnings, but they are allowed to deduct half of that from their income taxes. Starting in January 2013, taxpayers making an adjusted gross income (AGI) of more than $200,000 for an individual or $250,000 for a couple will have to kick in an additional 0.9% on wage and salary income above those thresholds, taking the top Medicare payroll tax rate to 3.8%. The extra tax is imposed directly on employees, so the top tax rate on employees would rise from 1.45% to 2.35%; employers will not have to pay more nor will they deduct additional withholdings from employee paychecks. The self-employed will experience comparable increases on their earnings over the income thresholds; the new levy is not deductible from their income taxes.
In addition, the new 3.8% Medicare tax will be imposed on investment income exceeding those income thresholds. For example, a couple earning $220,000 in salary income and $50,000 in dividends would pay extra taxes amounting to 3.8% on the $20,000 of investment income over the income threshold of 250,000. The IRS has not completely clarified what constitutes investment income for these taxes, but we think the following is likely. The new tax would apply to dividends, taxable interest, rents, royalties, net capital gains, the taxable portion of annuity payments, income from the sale of a principal home above certain thresholds, any net gain from the sale of a second home, and private-equity managersâ profits on leveraged buyouts (âcarried interestâ). The tax would not apply to payouts from a regular or Roth IRA or 401(k) plan, pension benefits, Social Security income, annuities that are part of a retirement plan, life-insurance proceeds, municipal-bond interest, veteransâ benefits, or small business income.
An estimated 4.1 million households, or 2.4% of Americans, would pay one or both of the new ACA taxes (3).
In effect, a new income tax system will come into being, working in parallel with the old income tax. Moreover, the thresholds for the higher tax rates are not indexed for inflation, so over time, an increasing share of households will be subject to these higher tax rates, a feature it shares with the AMT.
There are other smaller tax hikes in the ACA. Currently, there is no federal limit on contributions to an employer-sponsored Healthcare Flexible Spending Account (FSA) plan, although some firms impose their own limits. The amounts an employee contributes to a Healthcare FSA plan is deducted from taxable salary. Employees can withdraw funds tax-free from Healthcare FSA balances to cover qualified medical expenses. Starting in 2013, the maximum annual Healthcare FSA contribution per employee will be capped at $2,500. Under current law, a taxpayer can deduct itemized medical expenses to the extent that such expenses exceed 7.5% of AGI. Starting in 2013, that hurdle is raised to 10% of AGI, except for taxpayers aged 65 years or older, for whom the increase in the hurdle will not take effect until 2017. In addition, the ACA will impose a series of excise taxes on medical devices, which will begin in 2013. A 2.3% excise tax will apply to medical devices that are not purchased directly by consumers, such as hip implants and coronary stents. Similar fees and taxes will be imposed on health insurers, pharmaceutical companies, and indoor tanning services.
The Supreme Court recently ruled in favor of most of the provisions of the ACA. Unless the new Congress and the president overturn the ACA taxes in early 2013, the ACA tax provisions will start January 1, 2013, as scheduled by law. These new ACA tax hikes would amount to $24 billion in 2013.
Taxes on Investment Income
Tax rates on dividends and capital gains will rise significantly in 2013 under current law.
The maximum personal income tax rate on long-term capital gains is currently 15%. The new Medicare taxes would add an additional layer of taxation, boosting the top rate to 18.8%. If the Bush income tax cuts expire as scheduled, the maximum income tax rate on capital gains would rise to 20%; combined with the Medicare tax, it would reach 23.8%.
For qualified dividends, the maximum personal income tax rate is currently 15%. The new Medicare taxes would add an additional 3.8 percentage points, making the top rate 18.8%. If the Bush tax cuts expire as scheduled so that dividends are taxed as ordinary income, the maximum income tax rate would rise to 39.6%; combined with the new Medicare tax, the result would be a top rate of 43.4% on dividend income.
The maximum personal income tax rate on taxable interest is currently 35%. The new Medicare taxes would add an additional 3.8 percentage points, making the top rate 38.8%. If the Bush tax cuts expire as scheduled, the maximum income tax rate would rise to 39.6%; combined with the new Medicare tax, the result would be a top rate of 43.4%, the same as for dividends.
Congress and President Obama reached a last-minute deal in August 2011 to hike the federal debt ceiling by agreeing to measures to control federal spending. The legislation, called The Budget Control Act (or BCA), called for $917 billion in specific cuts to âdiscretionary spendingâ and, to a lesser extent, âentitlement spendingâ over the next decade. (Discretionary spending is set directly by Congress, while entitlement spending is produced automatically by federal programs.)
The BCA also established a Congressional âSuper Committeeâ charged with making recommendations for achieving a further $1.5 trillion in deficit reduction over the same time period. The committeeâs recommendations were supposed to be presented to Congress last November and voted on before the end of 2011. Alas, even after extensive negotiations, the Super Committee failed to reach an agreement; the two parties are simply too far apart in their approaches to deficit reduction. Under the terms of the BCA, this failure will trigger a schedule of automatic spending cuts (a âsequesterâ) starting in January 2013. The sequester amounts to a cumulative $1.2 trillion; the cuts would be $109 billion per year for 11 years, shared equally by defense and nondefense spending. Technically speaking, the law cuts budget authority, which is not exactly the same thing as cutting actual outlays because the government does not always spend as much money as authorized. Using guidance from the CBO, if the sequester starts in January as scheduled, a reduction in actual outlays amounting to $87 billion in 2013 is a reasonable estimate. The defense industry is especially vulnerable in 2013 because it is already being hit by the winding down of spending involving Iraq and Afghanistan and by the restrictions on discretionary spending imposed by the BCA; further cuts by the sequester would be a third round of reductions.
Because the sequester would be painful, Congress has great incentive to find and pass an alternative set of spending limits, but it can only do so if both parties agree. Typically, sequesters are avoided as Congress finds better alternatives. Perhaps Congress will do so again. Unemployment Compensation The Middle Class Tax Relief and Job Creation Act of 2012 extended emergency unemployment benefits through the end of 2012, although at a lower level than in 2011. If they expire on schedule, personal income would be cut by $35 billion in 2013.
The âDoc Fixâ
In its perennial attempt to rein in surging Medicare costs, Congress in 1997 imposed a severe 32% cut in the reimbursement rates that physicians receive for treating Medicare patients. Those cuts are always scheduled to take place, but to date, they have not been implemented. Congress has repeatedly delayed the start date of the cut in reimbursement rates, an action dubbed the âdoc fix.â Indeed, reimbursement rates are typically raised, but not by much. The reasons are not hard to find: physicians have significant lobbying power, and in any event, they can choose to stop treating Medicare patients if reimbursement rates are pushed too low.
The most recent edition of the doc fix is scheduled to expire at the end of 2012. Unless it is renewed yet again, payments to physicians will drop by $15 billion in 2013.
Adding It Up
All of the spending hits and tax increases listed above, plus an additional $140 billion in miscellaneous spending and revenue adjustments that the CBO does not itemize, would together reduce the 2013 federal budget deficit by an astounding $808 billion. That amounts to 5.2% of our estimate of gross domestic product (GDP) for 2012. That would be one of the largest tax increases in US history outside of a major war.
Note that is a static estimate because it does not take into account the economic feedbacks that such a bout of fiscal austerity would produce. For example, to the extent that higher taxes on investment income reduce capital spending or that higher payroll taxes reduce consumer spending, national income would be lower than otherwise and, consequently, so would tax revenue.
THE ECONOMIC IMPACT OF DRIVING OFF THE FISCAL CLIFF
I do not believe we can accurately forecast what would happen to the US or global economies if the federal government drives off the fiscal cliff. There are too many imponderables. Still, I think we can give a general description of the potential consequences. Both the demand side and the supply side of the economy would be slammed hard.
The Recession of 2013
Government spending would be cut sharply because of the sequester. The impact would be complex and uneven. For example, the sharp cuts in military spending would hit the defense industry hard, and major businesses in that sector have warned that they would have to layoff thousands of workers as contracts get cancelled.
Consumers would suffer a substantial decrease in their after-tax incomes, mostly because of higher taxes on incomes, wages and estates, but also because of cuts in unemployment compensation. Consumers would certainty slash spending in response to a large drop in their incomes.
Workers, facing higher tax rates, would have less incentive to work harder or longer in 2013, but those who have discretion over their hours might want to work more in the second half of 2012 when tax rates are lower. On the other hand, those unemployed facing a cut in unemployment compensation in 2013 might find it necessary to accept lower-paying jobs instead of continuing a search for higher-paying jobs.
Businesses would likely reduce capital investment. They would be burdened by less generous depreciation allowances and much higher tax rates on dividends and capital gains, all of which would raise the cost of capital. A higher cost of capital raises the rate of return companies require on investment projects; less profitable investments would be dropped. Moreover, the slump in spending by consumers and government would also give businesses reason to delay investment.
The CBO baseline forecast is based on current law, meaning that its baseline assumes the federal government drives off the fiscal cliff. The grim view of the CBO is that real GDP would contract 1.3% annualized in the first half of 2013 but a recovery with growth of 2.3% annualized would begin in the second half of 2013. For 2013 as a whole, real GDP would rise a mere 0.5%. By contrast, if all current fiscal policies were extended so that there was no fiscal tightening in 2013, the CBO estimates that real GDP would rise 4.4%.
Sorry to say, I think the CBO baseline, grim as it is, is overly optimistic. The CBO forecast with no fiscal tightening strikes me as having projected real GDP growth over a percentage point higher than seems likely. That implies that if the economy goes over the fiscal cliff, the recession would be more severe than the CBO projects.
The stock market would be hit by a double-whammy. According to standard financial economics, the value of the stock market is the discounted value of future cash flows. The first whammy is that a recession would hurt the stock market by reducing future cash flows. The second whammy is that the discount rate for valuing future cash flows would rise because it depends on, among other things, on the tax rates on dividends and capital gains and depreciation allowances. This double-whammy likely would likely result in a significant correction to stock prices, with perceived safer dividend-oriented stocks exposed to this unhappy scenario just as non-dividend payors are exposed because of the worst-case change in taxation.
To cushion the blow of a substantial fiscal tightening, we believe the Fed would initiate a major âquantitative easingâ (QE) program, which involves expanding the Fed balance sheet substantially via open market purchases of long-term Treasury securities and agency mortgage-backed securities (MBS).
The combination of substantial fiscal tightening and Fed QE would likely push down Treasury bond yields. I would not be surprised if the yield on the benchmark 10-year Treasury fell below 1.00%. That may seem extreme, but remember that the comparable yields in Japan and Switzerland are below 1.00%. On the other hand, another recession would likely drive up yields on higher-risk corporate bonds, as is typical in a recession.
2012 and 2014: Slowdowns Before and After the Recession
It gets even more complicated.
The impending fiscal cliff could cause some strange behavior in late 2012. Faced with a potentially much higher capital gains tax rate in 2013, higher-income households may engage in a wave of tax-related asset sales in late 2012 to take advantage of this yearâs lower tax rates. Something similar happened in late 1986, when households knew the capital gains tax rate was going to rise in 1987. Faced with a much higher dividend tax rate in 2013, businesses may pull forward some dividend payments and profit distributions into 2012. Businesses that typically compensate employees with bonuses may move up some payments from 2013 into 2012 so that the employees could pay a lower income tax on their bonuses. The result is that personal and taxable income might appear surprisingly high in late 2012.
Consumers may not experience the actual tax hikes until January, but to the extent that they are forwardlooking, anxieties about higher taxes could persuade many to start trimming their spending in late 2012. Insofar as consumer expenditures constitute about 70% of GDP, even a mild slowing in the pace of expenditures would weaken the economy. In other words, we might have a milder recession in the first half of 2013 at the expense of slower growth in the second half of 2012.
Knowing that depreciation allowances will be less generous in 2013, some businesses may pull forward investment from 2013 into 2012 to lower their taxes. The result would be somewhat higher business investment in the second half of 2012 and somewhat lower investment in the first half of 2013. Something similar happened when the 100% deduction for qualified capital expenditures expired at the start of 2012: business capital spending was stronger in the second half of 2011 than in the first half of 2012 as businesses moved to take advantage of tax provisions about to expire.
Other businesses may delay investment and hiring. When considering major investment projects, business expansion, product rollouts, or new hiring programs, businesses must, at least implicitly, have a sense about the near-term business climate. If businesses worry about a recession, a slump in consumer spending, a hike in business taxes, or massive cutbacks in new government orders, they may find it prudent to postpone such activities until there is greater clarity about the direction of the economy. If all businesses become cautious at the same time, the result can be an economic slowdown. Sometimes uncertainty and anxiety about possible policy changes can matter just as much as actual policy changes. The two industries most at risk may be defense firms and utility companies.
A piece of legislation from 1988, the Worker Adjustment and Retraining Notification Act (WARN Act) may further dampen consumer and business sentiment. This law requires that firms with at least 100 full-time employees anticipating mass layoffs or plant closings must provide 60 daysâ notice to affected employees (some states, including California and New York, require 90 days). The lawâs aim was to provide a window for workers to look for new jobs while they were still on payroll. Some companies that would be hard hit by the budget sequester, particularly defense firms, have concluded that they will see major projects cancelled, which will result in massive layoffs starting in January. To comply with the requirements of the WARN Act, they will have to make layoff announcements at the start of November. Such announcements could have a depressing impact on consumer confidence and spending, which would be especially damaging during the holiday November/December retail season. Moreover, the announcements would be made just days before the national elections, possibly influencing voter decisions. The defense contractor Lockheed Martin has said it may notify more than 100,000 employees of potential layoffs ahead of the election. EADS (a major European defense contractor with US operations), Northrop Grumman, General Dynamics, and Boeing are reviewing their situations and may issue layoff announcements (4).
The prospect of driving off the fiscal liff could also harm the economy in the first half of 2014. The reason is that not all of the higher tax liabilities for 2013 would be paid through increased savings or paycheck withholdings during 2013. For example, payments for the new ACA taxes, the AMT, and higher estate taxes would not be withheld in 2013 but would be payable in 2014. Households that do not adjust their 2013 withholdings would face a larger tax bill to be paid during the tax season in 2014; sending larger checks to the IRS in 2014 could be a drag on consumer spending.
It would be a mistake to focus exclusively on the US economy and ignore the rest of the world. By early summer 2012, there were clear signs that the global economy was slowing. Europe continues to stumble from crisis to crisis as its new euro-wide institutions are tested and stressed in ways that the euroâs founders never anticipated. Severe fiscal austerity in parts of Europe and an unsettled banking system have pushed much of Europe into recession. In addition, there are signs of slowing growth in China, India and Brazil. If the US were to fall into recession in early 2013 while the rest of world is struggling to find its feet, economically speaking, the result could be a global recession.
THE DEBT CEILING DEBATE: DĂJĂ VU
As if the fiscal cliff were not complicated enough, the US will soon face another debate about raising the federal debt ceiling. We think federal debt will hit its legislated debt ceiling of $16.4 trillion near the end of 2012. The US Treasury will be able to buy some extra time using accounting techniques, as it did in the summer of 2011, to keep the federal government operating even after the debt ceiling is hit. But such tactics can only work for so long. Sometime in the first quarter of 2013, the Treasury will run out of wiggle room, and if the debt ceiling is not raised, the US government would experience a partial shutdown, and there could even be a selective default on Treasury securities.
Congress will debate raising the debt ceiling, as it has many times. The participants have an incentive to continue negotiations until the last minute because this pressures their adversaries to make compromises. The likely outcome of the debate, in our view, will be a last-minute increase in the debt ceiling, similar to what happened in August 2011. The debate is sure to be rancorous as the two parties argue on how to slow the rise in federal debt. Such debates will be revisited time and time again until the country has a better sense of which adjustments it is willing to make to bring the federal budget into balance.
My optimism that the debt ceiling will be eventually raised and that the federal government will avoid default is tempered by pessimism about how another debt-ceiling debate may affect consumer and business confidence in a fragile recovery. The summer of 2011 afforded some bad experience with these matters: As the debt ceiling debate flared in June and July and investors wondered whether the US government would default, various surveys of confidence and sentiment slumped, measures of policy uncertainty surged, the pace of payroll increases slowed, the unemployment rate edged up, and the stock market fell. Granted, some of the economic slowdown should be attributed to the surge in oil prices and financial commotion in Europe, but the timing of the deterioration in survey results suggests that the debt-ceiling debate took a toll on the economy. It could happen again.
In a nightmarish scenario, the US could drive off the fiscal cliff in January, shaking the economy badly. Meanwhile, Congress and the president could get bogged down in a fierce battle in early 2013 over raising the debt ceiling, further depressing sentiment and raising uncertainty. It could be a grim time for the economy.
In our opinion, the best bet is that the US will not drive off the fiscal cliff in 2013, although we do expect fiscal policy to tighten significantly, probably about one-third of the size of the fiscal cliff. We also expect the debt ceiling to be raised in early 2013 as part of a fiscal agreement; the US will not default on its debt, in our view.
In particular, we expect the Social Security payroll tax cut and extended unemployment benefits to expire as scheduled. We expect moderate reductions in discretionary federal outlays, both defense and nondefense, but we do not think the sequester will be implemented. We expect a renewal of the doc fix and another patch for the AMT for 2012 and 2013, as has been the tradition. The new ACA taxes will be implemented as scheduled, although the Republicans will work hard to repeal them. We do not expect that all of the Bush income tax cuts will be allowed to expire, but we do not think Congress will miss an opportunity to raise more revenue. Rather, we expect that income tax revenues will be boosted, perhaps by capping tax deductions rather than raising tax rates. For the time being, we believe the estate tax will be kept as is. Some expiring tax provisions will be renewed, but the extra capital spending allowances will expire as scheduled.
This amount of fiscal austerity does not match driving off the fiscal cliff, but we believe it would reduce real GDP growth in 2013 by about a percentage point relative to what would happen if current policies were maintained.
We are not sure about the exact schedule for avoiding the fiscal cliff. Few expect Congress and the president to agree on anything before the November 6 election. What happens during the six-week âlame-duckâ session of Congress after the election will depend on the electionâs outcome. There is a good chance that there will be a repeat of the December 2010 deal, when the lame-duck Congress and the president agreed to a temporary extension of all tax cuts to keep the recovery going. Alternatively, there is also a chance nothing will get done until January, when the new Congress convenes and quickly delays the fiscal tightening that started January 1, thereby giving the new government some breathing room to negotiate a better fiscal package. We will see soon enough.
We believe one consequence of fiscal tightening is that the Fed will delay any tightening of monetary policy until the second half of 2014, or later. The economy can absorb only so much policy tightening in a short time period. Indeed, we think it likely that the Fed will continue its current policy of buying long-term Treasury securities.
Another consequence of the combination of fiscal tightening and monetary ease in 2013 is that Treasury bond yields should stay relatively low. A shrinking budget deficit, low inflation, and sluggish GDP growthâ all of which we forecastâare commonly associated with low bond yields. That said, bond yields will also be influenced by how the financial crisis in Europe plays out.
Finally, in our view, the uncertainty about how the fiscal cliff situation will be eventually resolved has had, and will continue to have, a depressing impact on economic activity in the second half of 2012. Even if the fiscal cliff is averted with a last-minute political solution in late December, it will be too late; the damage caused by uncertainty would already have been done.
If fiscal tightening is a drag on the economy, then why do it at all? It needs to be done to prevent the US public debt from swelling to unsustainably high levels, levels that would set off a financial crisis. In other words, for the US, the price of not correcting the fiscal imbalance would be turning into the next version of Greece. But the US federal government, unlike Greece, is truly too big to fail. The world cannot afford to see US Treasurys turn into junk bonds in the decades ahead. These are precisely the concerns of the ratings agencies.
THE RATINGS AGENCIES
On August 5, 2011, Standard & Poorâs (S&P) lowered its rating on US sovereign long-term debt from AAA to AA+, and left the rating on negative outlook, indicating that another notch downgrade could come within two years. S&P justified the downgrade because of the continued failure of the political system to produce a fiscal consolidation sufficient to prevent ongoing excessive budget deficits. In S&Pâs view, the BCA that was passed in early August 2011 was not sufficient to stabilize the debt-to-GDP ratio.
Moodyâs and Fitch did not downgrade US Treasurys, but both agencies have put Treasurys on a negative outlook warning. They, too, are concerned that the federal government has no plan for reducing its deficits to sustainable levels, but they have been more patient than S&P in giving the government time to work out a plan.
All three of the major ratings agencies have said they are waiting to see the results of the November elections and the kind of fiscal proposals the next administration and Congress will agree on, whoever wins. They have warned that failure to implement a plan to stabilize the national debt relative to GDP would be reason to downgrade Treasurys in the case of Moodyâs and Fitch, and to downgrade Treasurys again in the case of S&P.
The ratings agencies are not urging the US to drive off the fiscal cliff. They are simply observing that a sovereign that wants a top rating must implement a sustainable fiscal policy. We believe that if the US adopts the degree of fiscal tightening in 2013 that we have in our baseline scenario, the country will probably avoid further rating downgrades in the near term.
The danger is that if, contrary to our assumptions, the US avoids the fiscal cliff by extending all current fiscal policies but fails to implement a long-term plan for shrinking the budget deficit, all three major ratings agencies could downgrade Treasurys by the end of 2013.
It is not as though the US has not made a fiscal blunder before. After the terrible economic collapse that ran from late 1929 to early 1933, the US experienced a solid rebound in national output during the following four years. Unfortunately, policy blunders killed the recovery before it was complete. President Roosevelt was deeply concerned about the sizable federal budget deficit after his reelection in 1936, and he implemented a series of large tax hikes, many of them focused on the business sector. Those policies contributed to a severe recession in 1937-1938.
The American people are rightfully worried that current federal fiscal policy is unsustainable and could push the US into a financial crisis in the near-future. My view is that the US would benefit from a steady pace of fiscal tightening, but the pace in any one year should be moderate. If the US goes off the fiscal cliff in January 2013, that would be a more rapid fiscal adjustment than the recovery could withstand. It would produce an unnecessary and undesirable recession.
Going off the fiscal cliff makes no economic sense, and I think the best bet is that the US will manage to avoid going off the fiscal cliff. But as James Deanâs Jim Stark character understood, sometimes senseless things happen, sometimes mistakes are made, sometimes bad things happen to good people.
QualiďŹed dividends must meet IRS qualiďŹ cation standards, be paid by an American company or a qualifying foreign company, and comply with a dividend
holding period requirement.
(2) Congressional Budget OfďŹce, âEconomic Effects of Reducing the Fiscal Restraint That Is Scheduled To Occur In 2013,â May 2012.
(3) From Tax Policy Center, a nonpartisan research group located in Washington, DC
(4) Zachary A. Goldfarb, âAs âďŹscal cliffâ looms, debate over pre-Election Day layoff notices heats up,â Washington Post, July 30, 2012.
This information is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein
reflect the subjective judgments and assumptions of the author only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P., or any
portfolio manager. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as
forecasted and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice. MALR009494 LEGREV22213
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