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Questions and Answers Surrounding the Fiscal CliffAnalysis

Northern Trust
December 4, 2012


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There is no resolution yet to the US fiscal cliff. It is probably unfair to have expected one by now; the clock is too far from midnight. But as the negotiations continue, several questions have been raised that deserve some reflection. 

1. The two sides seem to be making statements that reflect stark disagreement. Are talks failing?

Not necessarily. Public posturing is part of the process; it serves the purpose of sending a message to both your side and the other side. Keep in mind that real bargaining rarely happens in front of the cameras; a back room is the more common, and appropriate, setting for give and take. The fact that each side has advanced a set of increasingly specific ideas represents progress over the pre-election period. 

2. Is our fiscal path a cliff, or a slope? 

The difference in topography between the two formations is supposed to describe alternative economic progressions for 2013. Going off a cliff initiates a very sudden fall, while a slope implies a gentler descent. 

Several elements of the federal tax and spending changes set to go into effect on January 1 may not reach full force for a while. For example, it may take time for consumers to adjust their spending habits to lower levels of post-tax income. Some expenditures will be cut immediately, while other reductions will be phased in gradually. 

Those seeing a slope conclude that ending December without agreement would not be disastrous, since the sacrifice of economic activity would not be fully felt for some time. In this scenario, discussions could continue into the new year, and if an agreement is reached sometime in January, little harm will have been done. 

What this overlooks is the negative reaction to failure, which would be swift and severe. Businesses would defer investments in physical and human capital that rely on tax clarity. Consumer confidence could retreat, as it did during the budget impasse in the summer of 2011. (Confidence continued to slide for quite some time after agreement was reached in that case.) Rating agencies could be expected to downgrade US Treasury debt without delay. And investors could take our markets down sharply, reinforcing poor psychology and creating a negative wealth effect. 

So whether fiscal changes trace a cliff or a slope, failure to reach agreement before Christmas will prompt a sharp response. Time is therefore not on the side of the negotiators. 

3. There is a proposal to limit the deductions claimed by high income taxpayers. How would these work, and what are the consequences? 

Speaker Boehner made a revenue-raising offer of $800 billion over ten years that rests on limiting deductions. Specific details have yet to be offered, but research from the Committee for a Responsible Federal Budget (CRFB) includes options that would translate into higher revenues without tax rate increases. All limit (or eliminate) preferences based on the volume of deductions or the level of income. 

All of the alternative designs have the potential for unevenness and unintended consequences. For example, those who live in high income tax states would be more limited in taking other deductions; this would effectively raise the cost of home ownership by forcing them to bear the full cost of mortgage interest and property taxes. Upper-income taxpayers who reach the deduction threshold with mortgage interest and state and local taxes might reduce their charitable contributions. And effective tax rates would show a pronounced spike at certain levels, as apart from the more continuous system now in place. 

Of course, the alternative of raising marginal rates and leaving deductions untouched is not without consequences. Most prominently, this step could discourage the investment that is thought to be very important to long-run economic performance. 

The fact is that there are no painless alternatives. Whether the cliff takes root or a compromise is reached, there will be winners and losers to tally up. 

4. The cliff has been in the news for a long time. Why isn’t everyone prepared for it? 

While the risk of going off the cliff has been discussed for many months, the consensus has remained that the worst outcome would not come to pass. Few forecasts, for example, have the economy falling back into the recession that the Congressional Budget Office (CBO) predicts if Congress and the Administration cannot compromise. This is the scenario embedded in equity markets, which could be expected to correct importantly if tail risk rises.



Further, one gets the sense that the average household is not fully aware of the impact that cliff elements will have on them. Beyond the impact of rising income tax rates, all wage earners will see payroll taxes revert to former levels. The AMT could hit another 20-25 million households. Unemployment benefits will abruptly end for many families. The average tax burden would rise by nearly $3,500. 

As holiday sales to date suggest, households do not seem to be setting their budgets in anticipation of such a significant moderation in their resources. So they could be in for quite a shock. 

5. Would it really be so bad if we went over the cliff? 

Some analysts are less alarmed by the possible failure of this month’s negotiations. They point out that:

a) Even in the CBO’s calculations, the US economy would return to growth in the second half of next year after a brief interruption.

b) In light of this, markets focused on long-term trends (like stocks) might not be phased. 

c) The cliff is a credible course toward long-term deficit reduction. And it requires no further legislative approval.

d) It seems to make both sides unhappy, which could suggest that it successfully mediates their interests.

This analysis is interesting, but ignores the spectrum of psychological consequences that could affect market and economic performance. Media coverage on the other side of the cliff would almost certainly accentuate the hardships faced by taxpayers and those affected by spending cuts, leaving aside any long-term benefits of budget discipline. 

Those that view the scenarios only through the lens of complicated budget scoring miss these more visceral carry overs that could be very damaging to the economy. 

As one who certainly understands what’s at stake, I have been trimming my holiday spending plans. As my children open their homemade necklaces and second-hand board games later this month, I’ll recommend that they express any discontent to Capitol Hill and the White House.

 

(C) Northern Trust

www.northerntrust.com

 

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