At the Brink of the Fiscal Cliff
Most of us are aware that automatic spending cuts (known as sequestrations) are scheduled to take place on January 1, 2013, the result of the Budget Control Act of 2011. Conceptually, deep cuts appear desirable because they would force a reduction in federal spending across the board — something we’ve been unable to accomplish through an increasingly contentious political process.
Also looming at the stroke of midnight on January 1, 2013, are some of the most significant changes in tax policy in more than a decade. The more onerous changes include an automatic return to higher individual tax rates (all marginal brackets), an increase in rates on long-term capital gains, a new surtax on income for high earners to pay for the Patient Protection and Affordable Care Act (PPACA), and a revamp of estate tax laws.
Together, this convergence of budget trimming and tax hikes has been dubbed the “fiscal cliff.” These changes have been projected to reduce the 2013 deficit by roughly half, and the cumulative deficit over the next 10 years by as much at $7 trillion. Regardless of that apparently desirable outcome, it is likely that Congress will step in to amend or repeal the changes, either during the lame duck session after the November elections or early next year. Why?
Not surprisingly, the changes are politically unpopular. And as always, there are the many disparate opinions over the economic impact of the fiscal cliff, as well as rising skepticism over the supposed long-term benefits versus the short-term consequences.
This is debt reduction?
If the primary goal of automatic spending cuts is to reduce our debt burden, then the policy will fail. All projections we have seen don’t show a reduction in our overall debt levels, but merely a reduction in their rate of growth. For instance, the following graph from the Congressional Budget Office (CBO) shows the baseline scenario (full fiscal cliff) with the current deficit of 8.5 percent falling to under 2 percent by 2021. While such reductions would be an improvement, it is still a deficit. More importantly, public debt would still rise from 69 percent of gross domestic product (GDP) to 84 percent of GDP by 2035, according to the CBO.
Source: Congressional Budget Office
It’s even possible that the cuts could do more harm than good. According to published analysis from Goldman Sachs, the cumulative effect of the full fiscal cliff would be a roughly 4 percent reduction in GDP in 2013. If Goldman is correct, then the United States will fall into a recession in 2014. Current real GDP growth is about 1.5 percent — a growth rate unlikely to improve over the next two quarters. Therefore, allowing the full impact of the fiscal cliff implies a 2.5 percent contraction in output, which is not by any means a mild recession. It’s not hard to predict what will happen to employment levels if we fall back into recession.
Granted, Goldman may be biased in its viewpoint, but the firm is probably not alone in its assessment. In any case, given elasticity in corporate profitability and in incomes for high earners, there would certainly be a substantial drop in tax revenue if we fall into recession. It is even conceivable that revenue shortfalls would approach the level of spending cuts, virtually cancelling out the intended benefits of reduced spending.
The following chart shows Goldman’s assumptions for the impact or “drag” on GDP growth due to the fiscal policy changes in 2013. Unlike the CBO, whose baseline scenario assumes the full fiscal cliff, Goldman’s starting point assumes the expiration of payroll tax cuts, the phase out of emergency unemployment compensation, and an extension of the 2001 and 2003 tax cuts. They also assume that the automatic sequestration is deferred and replaced by a much smaller amount of belt tightening. Lastly, Goldman assumes that the new Medicare surtax on upper incomes enacted under the PPACA would take effect on schedule.
The chart also shows two alternative paths for fiscal policy: the more benign effect on near-term growth if all impending policy changes were delayed, and the much more severe effect on growth that would occur if the entire package of tax increases and budget cuts were allowed to stand. It is interesting to note that Goldman’s projections show a fairly temporary impact. We would expect a more extended drag on growth, though the modeling is highly imprecise.
Source: Goldman Sachs Global ECS Research
A Congressional stalemate on taxes
So far, Congress has not been able to agree on a direction for taxes. The Senate voted to extend the 2001 and 2003 tax cuts on income below $250,000, but rejected legislation to extend all of the cuts. The House, on the other hand, has voted to extend the 2001 and 2003 tax cuts on all levels of income, while rejecting a bill to extend the tax cuts only on income below $250,000. Both sides are holding to their party lines, and they remain far apart on the path the country will take on taxation.
The speed with which the fiscal cliff negatively affects economic activity will also depend on whether consumers view the adjustments as temporary or permanent. If it appears that Congress intends to extend expiring tax cuts, consumers might be willing to look beyond the temporary reduction in disposable income next year if the eventual outcome would be a return to some form of the current policy. On the other hand, if the fiscal cliff were to take full effect because of political gridlock, consumers would likely be cautious, reduce their spending, deepening the negative impact of the changes.
Given the expected impact to GDP growth, we expect Congress to resolve these issues in its lame duck session after the November elections. However, there is certainly a risk that politicians will fail to agree and we will experience the full fiscal cliff in 2013. If so, we won’t have to rely on economic modeling for long to determine the impact of the changes.
Is this time different?
In their book This Time is Different (Princeton University Press, 2009), Economists Dr. Carmen M. Reinhart and Dr. Kenneth S. Rogoff conclude that financial crises are fairly cyclical, and predictable. In their research, they studied eight centuries of data across 66 countries and 5 continents. They found that boom and bust cycles occur in clusters and strike with surprising consistency. In addition, they found that there are common elements to all boom and bust cycles, which I have oversimplified for brevity:
- Boom — Deregulation and loose monetary policy lead to higher leverage ratios, increasing both profits and margins.
- Bust — Rapidly falling profits and asset prices lead to a financial crisis requiring deleveraging and often debt default. A bust follows a substantial boom in which assets and risk inevitably become mispriced. Central bank response to the bust phase leads to a period of rapidly rising public debt.
The financial crisis in 2008 was right out of this textbook, as has been the Fed’s response. Rogoff and Reinhart’s data also provide fairly compelling evidence for what follows. Countries with debt-to-GDP ratios over 70 percent tend to fall into a pattern of lower GDP growth, and chronic high unemployment. More troubling are countries with a debt-to-GDP ratio over 90 percent. Historically, these nations have faced a fragile economic future of significantly higher unemployment, coupled with higher rates of inflation, eventual debt default, and currency devaluation. Governments faced with higher debt service costs and slower growth typically raise taxes and engage in austerity programs in an effort to raise revenue and reduce expenses. Both typically result in lower levels of employment as employers adjust for reduced demand, which then leads to falling revenue.
Faced with no other options, currency devaluation (hyper-inflation) eventually becomes the policy tool of last resort. Will it be effective? Is it early enough to avoid the fate of so many other countries that have gone down this path before? While we don’t see a debt default in our near future, and we don’t see inflationary pressures for the next year or two, it is clear we need to be careful. Although some would suggest it is somehow different for the United States than it has been elsewhere, we have not seen the evidence to support that opinion.
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Mark A. Griffin, CIMA®
Principal, Chief Investment Officer
CliftonLarsonAllen Wealth Advisors, LLC (“CLA Wealth Advisors”)
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