You really have to give credit to the Founding Fathers of this Nation. More than 200 years ago they created a framework that continues to operate even today. One of the premises upon which they built our government is the fact that more often than not, doing nothing is better than SCREWING things UP!
That is why there are checks and balances amongst the three branches of government: Legislative, Executive and Judicial. The idea was the harder it was for government to pass laws, the fewer stupid laws would be passed to harm our nation. Well, we are sort of watching that happen as the country has been in gridlock for a little better than a year and in that time the economy is finally beginning to improve and the stock market is in a remarkable rally. However, do not breakout the champagne just yet…
Let’s share some facts because although it may not feel like we’re in a bull market, stocks are in the midst of an extended rally that has taken the S&P 500 index from below 1280 in early June to the mid 1400s currently. Yet whenever you read about America’s economic recovery, there is inevitably a mention of the looming fiscal cliff, a scary future event that could decimate the economy and drive share prices back down. The best analogy is a bullet train heading on the track speeding along but some idiot dismantled the bridge without telling the passengers as the train rushes towards its inevitable doom. The conductor and the trainman are arguing as to whether it is best to speed the train up and try to jump the gap or slam on the brakes. Yet, neither is willing to halt the train while they argue.
Unfortunately, you and I are the passengers paying for this fiasco! Congress and the administration (Democrats vs. Republicans) are the trainman and conductor. What is this fiscal cliff? Why are economists so frightened of it? The term refers to a sudden change in a lot of different tax policies that is scheduled to take place automatically at midnight on December 31st. As soon as the clock strikes twelve, the Bush-era tax cuts will expire, eliminating the 10% tax bracket altogether and moving the current 25%, 28%, 33% and 35% brackets up to 28%, 31%, 36% and 39.6% respectively. At the same time, the 0% capital gains tax rate would bump up to 10%, and the tax rate on dividends would rise to 15% or 28%, depending on the recipient’s income tax bracket.
Also expiring: a provision that eases the so-called “marriage penalty,” some deductions for college tuition, child tax credits, dependent care credits and a particularly harsh phase-out would eliminate up to 80% of some taxpayers’ itemized deductions for mortgage interest, state and local taxes, and charitable donations.
Making the cliff a bit steeper is the Budget Control Act of 2011, what most of us remember as the tense compromise that ended last year’s budget standoff. You may remember that gridlock resulted in automatic government spending cuts of $1.2 trillion from the federal budget over the next 10 years. The last time Congress and the Administration had a showdown over raising the debt ceiling the Government Accounting Office (GAO) found the cost of that showdown was $1.3 billion (in the form of greater government borrowing costs).Adding to the precipitous cliff, the Obama-era payroll tax cuts (which reduced taxes by about 2% for workers) expire at the same moment in time.
All of this would boost government revenues and lower government spending–the opposite of a government stimulus–and suck some of the spending power out of consumer balance sheets. How much? The Congressional Budget Office estimates that if we go over the cliff–that is, if Congress doesn’t act between now and the end of the year–a total of $560 billion would exit the economy to pay down the government deficit. That’s the good news. The bad news is that the CBO estimates that this would reduce America’s total economic activity in 2013 by four percentage points. That is $600 billion or between 6 to 12 million jobs. To put that in perspective, last year our economy grew at a 1.7% rate which is an increase in activity of $255 billion and an increase of 2.5 million jobs.
So is a recession inevitable? What are the odds that Congress will take bold, decisive action during a Presidential election year? Some pundits believe the magnitude of the economic consequences has gotten the attention of Congress, and that no matter who gets elected, something will be done. The most likely possibility, alas, is yet another stop-gap measure which might extend some of the tax cuts and repeal some of the automatic spending cuts, pushing the cliff out so that future lawmakers will have to deal with it–which is basically how we got in this mess in the first place. Under the Bush administration, the tax cuts were not made permanent because it had to be accounted for while using an expiration date meant it did not. So we have more than a decade’s worth politicians ducking bold action and passing the buck to the next set of politicians.
Meanwhile, as the U.S. economy continues to march straight toward the edge, a growing nervousness may be part of the reason why the economy has been so slow to recover. Businesses are reluctant to hire or invest in the future when there are serious questions about what that future will look like. The slow, steady rise in the stock market this summer suggests that when politicians are too occupied to focus on running the country, the economy improves and economic outlook grows! However, at some point the circus that nominates presidential candidates and elects presidents will cease and then Congress and the president will be at it again!
When that happens we will not be surprised that investors will believe that the politicians will set the economy on a collision course with a recession-causing event. The big question that none of us knows the answer to is: what will investors do when they look up and see the cliff? We do not know, but we would not be surprised if it is a white knuckle ride!
Sources:
http://www.smartmoney.com/taxes/income/how-the-expiring-bush-tax-cuts-affect-you/
http://bonds.about.com/od/Issues-in-the-News/a/What-Is-The-Fiscal-Cliff.htm
http://money.cnn.com/2012/07/23/news/economy/debt-limit/index.htm
