As we move into the fall election season, dangers associated with the “Fiscal Cliff” are becoming more of a possibility. Significant changes in the tax law and government spending will happen automatically if Congress does not come to an agreement before year’s end. These automatic changes are called a fiscal cliff because the economy will probably slow abruptly if nothing is done. The major elements of the fiscal cliff are:
Expiration of the Bush tax cuts. Tax rates that have been in effect for the past decade are due to expire at the end of 2012. Republicans believe the tax rates should be extended for all taxpayers until comprehensive tax reform is addressed and enacted. Democrats believe they should be extended only for middle and lower income families. President Obama has said he will veto any further extension of the Bush tax cuts for upper income families, those making more than $250,000 per couple.
Expiration of the payroll tax cut. In 2010, to obtain the President’s agreement to a two year extension of the Bush tax rates, the Republicans agreed to reduce employee Social Security taxes for 2011 from 6.2% to 4.2%. Later, Republicans agreed to extend this lower rate through 2012 without requiring an offset with tax increases or spending cuts elsewhere. The President argues that the lower employment tax rate puts money in workers’ pockets, which will help revive the economy. Republicans have expressed concern about the implications for the deficit. Many legislators believe that it is not good public policy to deplete funds available for Social Security.
New healthcare reform taxes. As part of the Affordable Care Act, Congress approved an additional tax on investment income, which will take effect January 1, 2013. For families with income above $250,000 ($200,000 for individuals), taxable investment income (interest, dividends, capital gains, rents, royalties) will be subject to an additional tax of 3.8%. Democrats will resist changes to their signature legislation.
Spending cuts. The compromise reached last August to increase the national debt ceiling called for automatic cuts in discretionary government spending of $2.1 trillion over ten years, about half from defense and half from social programs. Republicans would like to cut more, but reduce the amount allocated to defense. Democrats will not support additional cuts to social programs. The President has said he will veto any effort to unwind the agreement to reduce spending reached last August.
JPMorgan estimates that the economic consequence of failing to address the fiscal cliff would be a 3.5% reduction in GDP, which would throw the US economy back into a recession for at least the first half of 2013, a consequence confirmed by a report from the impartial Congressional Budget Office.
Congress is unlikely to pass any tax or spending legislation before Election Day. And no matter who wins the election, we will have the same Congress and President for the rest of the year. While there are many avenues for compromise, the possibility of a deadlock in the lame duck session of Congress cannot be dismissed. Rolling back the changes next year would only be possible if the Republicans win the presidency and both houses of Congress. Even so, there are procedural maneuvers in the Senate the Democrats might try to avoid or delay such a roll-back.
In addition to the economic consequences of this high stake game of chicken, in which both parties seek political advantage and a chance to promote their respective agendas for the country, we should expect markets to remain volatile for the rest of the year. Normally, markets are volatile before a national election, but calm down afterwards (regardless of who wins) as uncertainty is reduced. This year, volatility may increase after the election due to increasing uncertainty over the fiscal cliff. Furthermore, the threat of rising capital gains tax rates could prompt investors to sell assets before year’s end, putting additional pressure on markets.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. They are those of the authors. Investing involves risk, including loss of principal.