Fiscal Cliff

http://www.economicpolicyjournal.com/2012/11/what-is-fiscal-cliff.html

Thursday, November 8, 2012

What is the "Fiscal Cliff"?

Yesterday, I posted a report from Robert Kahn, an economist at the Council on Foreign Relations, on how the "kick the can down the road" compromise by Congress that he expects will develop to avoid going over the "fiscal cliff".

It turns out that proposal is mostly about raising taxes rather than cutting spending. Going over the fiscal cliff would be pretty much the same, more taxes and very limited cuts in spending, $532 in tax increases, $136 billion in spending cuts. WSJ has put together the graphic below.

=============================

http://www.econbrowser.com/archives/2012/11/going_over_the.html

November 04, 2012

Going over the fiscal cliff

The "fiscal cliff" refers to a broad set of tax increases and spending cuts that under current U.S. law will take effect in January. A recent assessment by Bank of America Merrill Lynch estimates the tax increases in 2012 could come to $470 B and spending cuts another $250 B, for a combined fiscal shock of $720 B, or 4.6% of GDP.

Source: Bank of America Merrill Lynch

A fiscal contraction of this size in an economy as weak as the United States would likely be enough to send the country back into a recession. Since that's not an outcome either party wants to see, my assumption has been that somehow Congress and the President will find a way to avoid it.
Some respected analysts have suggested to me that there is one political reason that our leaders might prefer to go over the cliff and then try to back our way up. The advantage is one of framing-- once we've gone over the cliff, their position can be described relative to the new status quo, namely, every politician can claim to be in favor of tax cuts, but with the Democrats opposing "new tax cuts for the wealthy."
If we were to drive over the cliff before trying to back up, one of the logistically cumbersome changes to undo involves the alternative minimum tax, since the changes here concern taxes owed on income earned in calendar year 2012. Business Week explains:

the number of households facing the alternative tax would increase to 32.9 million from 4.4 million, according to the Internal Revenue Service. That's an average unanticipated tax increase of about $2,800.
The effect from the AMT, as the parallel tax is known, would be immediate in early 2013 because Congress hasn't addressed the change for tax year 2012, and taxpayers start filing returns in January. A retroactive AMT change is much more cumbersome than retroactive changes in the 2013 income tax rates, which can be handled through paycheck-withholding adjustments, said Kenneth Kies, a Republican tax lobbyist in Washington.

Although discussions treat the "fiscal cliff" as a monolithic event, surely the outcome will be to break it up in pieces, with a likely consensus reached for another one-year extension of what Reuters describes as the "perennial patch" that exempts most Americans from the AMT. Indeed, Reuters reports:

the folks at Intuit Inc's TurboTax unit are so sure the feds will eventually do that AMT patch, they are already programming their software as if it's a done deal.

It should also be straightforward politically to reach a consensus on a one-year extension of the payroll tax cut. More complicated are the Bush tax cuts. Here's a summary of what's involved given by the Tax Foundation:

• The two "marriage penalty elimination" provisions will expire, so that:
• The standard deduction for married couples will fall, no longer double what it is for single filers; and
• The ceiling of the 15% bracket for married couples will fall, no longer double what it is for single filers
• The 10% tax bracket will expire, reverting to 15%
• The child tax credit will fall from $1,000 to $500
• The tax rate on long-term capital gains earned by middle- and upper-income people would rise from 15% to 20%
• The tax rate on qualified dividends earned by middle- and upper-income people would rise from 15% to ordinary wage tax rates
• The 25% tax rate would rise to 28%
• The 28% rate would rise to 31%
• The 33% rate would rise to 36%
• The 35% rate would rise to 39.6%
• The PEP and Pease provisions would be restored, rescinding from high-income people the value of some exemptions and deductions

The plan outlined in the Obama administration's budget is to allow only one of those 12 provisions to revert exactly to what it was in early 2001:

• The top tax rate will revert from 35% to 39.6%

Then there are the automatic spending cuts set to take effect in January as a result of the Budget Control Act of 2012, which calls for a 9.4% cut in defense spending, 8.2% cuts in spending outside of defense and entitlements, and a 2% reduction in the amount health-care providers receive from Medicare-- see the Center on Budget Policies and Priorities for details. In the third presidential debate, President Obama made the mysterious statement that

the sequester is not something that I've proposed. It is something that Congress has proposed. It will not happen.

What the President meant by that statement is unclear to many of us. But I would note that the "political framing" argument given above is a reason not to go over the cliff as far as the automatic spending cuts are concerned. Politicians on both sides will want to be on the record as voting for spending cuts, not increases, so finding a way to avoid the sequester, and later implement more modest versions of the cuts, might have some political advantages.
The most likely eventual outcome seems to me to be much more modest tax increases and spending cuts than implied by the full "fiscal cliff" scenario. A key question is then whether political brinksmanship, particularly the strategy of first going off the cliff before trying to find a way back up, could in and of itself exert significant costs. In my view the debt ceiling debacle last year did have a measurable effect on consumer sentiment and spending, though I don't see any evidence of a replay of that so far in the most recent sentiment readings.

Source: Calculated Risk

On the other hand, businesses, particularly those with a tie to defense spending, may be more anxious, and it is possible that recent weakness in business fixed investment is related to concerns about what's going to happen to federal spending and taxes. Moreover, the anticipated wrangling may have already locked in a decline in defense spending between 2012:Q3 and 2013:Q1.
It also is worth commenting on the dividend cliff. At the moment, the maximum tax rate on income from dividends is 15%. But under current law, in January we will see: (1) dividend earnings of high-income tax payers would come to be taxed at the regular income rate instead of the favored capital-gains rate, (2) the regular tax rate for upper-income households will rise from the current 35% to a new 39.6%; and (3) a 3.8% surtax will be added to dividend income of high-income investors. The combined effect of all three is that the maximum tax rate on dividends rises from a current value of 15% to a new value of 43.4%. That's a sufficiently big change that I would not want to rule out the possibility of a significant effect on equity valuations or corporate governance.

Posted by James Hamilton at November 4, 2012 12:59 PM



=====================

http://www.econbrowser.com/archives/2012/11/the_fiscal_clif_2.html

The Fiscal Cliff: International Implications

Most of the discussion has focused on the domestic repercussions of going off the fiscal cliff (or as my former colleague Chad Stone calls it, the “fiscal slope”). I think it important to remember that, as the single largest economy, policy in the US has profound implications for economic developments overseas. This is particularly true with the eurozone still in a fragile state, and China growing (relatively) slowly.

Jim’s post yesterday tabulated the numerical components of the fiscal cliff. Goldman Sachs has used its own tabulation to estimate the impact on GDP growth over 2013 (SAAR), shown in Figure 1.
Figure 1: Effect on real GDP. Source: Goldman Sachs, “US Daily : The Composition of the Fiscal Cliff (Alec Phillips),” October 19, 2012 [not online].
Note that one difference between the BofA and GS calculations involves the size of the Bush tax cuts. BofA indicates $180 bn, while GS indicates $192. The consequential piece of information is that $56 billion of the $192 bn is associated with high income tax cuts. Retaining the lower tax cuts for incomes less the $250K means the fiscal cliff would be reduced by $136 bn.
Nonetheless, with interest rates at zero, contractionary fiscal policy is likely to have large (negative) effects. (Obviously, I am ruling out “expansionary fiscal contraction”; strangely, I do not hear much discussion of this outcome being likely, this time around -- where is the Republican JEC when you need cheering up?).
The IMF, using slightly different numbers, concludes:

The fiscal contraction built into the fiscal cliff is 4 percent of GDP (3 percent of GDP more than in the WEO baseline). A range of models is used to consider the short-term impact of the fiscal cliff, from simple calculations with tax and expenditure multipliers to fuller scenarios using various modeling approaches, each of which has its own assumptions regarding the permanence of the cliff and associated confidence effects (Fig. 14). The largest—not necessarily the most likely—hit to US growth comes from the G-35 model because it treats the cliff as temporary (i.e., private consumption does not rise to offset lower public demand), and since it builds in negative confidence effects (i.e., a 15 percent drop in stock prices, partially offset by lower long bond yields on account of the lower debt path). The spillovers from this model are also larger, and operate mainly via trade channels, which is why neighbors are most affected (Fig. 15). But China and several advanced countries would also suffer up to one quarter of the hit taken by US growth. Lower commodity prices—6–12 percent for energy and 3–6 percent for non-energy, depending on confidence effects and policy responses—also adversely affects net exporters of these goods. Were the assumed confidence effects more negative, so would be the spillovers. (page 10)

Exhibit 14 from the paper tabulates the various estimated impacts and assumptions.

Exhibit 14 from IMF (2012). The estimated impacts are relative to WEO baseline (which includes a 1 ppt of GDP contraction), so they pertain to a 3 ppts of GDP contraction. Multipliers pertains to application of multipliers as in most of the calculations, e.g., GS. GIMF, GPM and G35 are Global Integrated Monetary and Fiscal model [1], Global Projection Model [2] and a panel unobserved components model of 35 economies (Vitek 2012) [3].
The (relative) impact on economies around the world is illustrated in Exhibit 15.

Exhibit 15 from IMF (2012). Clearly, the impact is (relatively) largest for our neighbors, Canada and Mexico. But the impact on some other economies in a precarious state –- the UK, Germany, China, and Japan –- is also noticeable.
I would further note that expansionary monetary policy -- such as implemented recently by the Fed in QE3 -- cannot offset completely the contractionary impact of contractionary fiscal policy. In addition to the zero interest rate constraint, looser Fed policy tends to re-allocate economic activity toward the US.
Hence, the stakes for a successful resolution of the fiscal cliff are high, not just for the US, but for the world economy.
More on this from the CBO report released today.

Posted by Menzie Chinn at November 8, 2012 09:03 AM