What is the Fiscal Cliff? And How It Can Drive America into Recession

What is the Fiscal Cliff? And How It Can Drive America into Recession

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Now that President Obama has won a second term in office, the attention of Wall Street has immediately turned onto the looming fiscal cliff. To underline the importance of the issue, asset manager Blackrock along with several other state pension boards took out full page advertisements on the eve of the election in the Wall Street Journal, New York Times and Washington Post to warn of the impending disaster.

Furthermore, on October 18, CEOs of major banks including JP Morgan, Goldman Sachs and Bank of America, signed an open letter pressing Congress and the President to “reach a bipartisan deal to avoid” the looming fiscal cliff. As it stands, should current laws stay exactly the same going into 2013, commentators are almost certain that the fiscal cliff will bring about another recession in the United States.

Just what is this fiscal cliff, and why is it so important for investors?

Essentially, the fiscal cliff represents a series of fiscal stimulus that will expire on the stroke of midnight on Dec 31, 2012. The four main drivers of the fiscal cliff are 1) the expiry of the Bush tax cuts, 2) expiry of the payroll tax cut, 3) ending of the emergency unemployment compensation passed in 2008 and 4) automatic budget cuts due to the Budget Control Act.

The expiry of the package of tax cuts, spending stimulus, and emergency benefits will all occur in 2013 and it is expected to contract the economy immediately by more than US$500 billion (>3% of GDP), almost guaranteeing the end of the economic recovery and ushering in a new recession.

1)   Expiry of the Bush tax cuts

As evidenced by the table below, the end of the Bush-era tax cuts will usher in a higher tax rate for almost every income bracket in the United States — resulting in an immediate hit to consumer’s disposable income for a total of slightly less than US$300 billion.

As a result, if Congress does not pass an extension of the current tax cuts, the range of marginal tax rates will increase from 10% – 35% in 2012 to 15% – 39.6%. Not only will the rich pay higher taxes, but the poorest will be hurt even more by an increase of 5% in their tax bracket. In addition, the Federal Child Tax Credit will also decrease to $500 per child (from $1,000 in 2012) and the maximum tax rate for long-term capital gains will increase from 15% to 20% — essentially raising the tax rate on dividend income.

2)   Expiry of 2% payroll tax cut

On Jan 1, 2013, employee payroll tax will increase by 2% as the expiry of a one-year tax holiday started in 2011 takes effect. The original ‘discount’ was extended to the end of 2012 and gives the American consumer an average of around US$1,000 per year in additional disposable income. In total, that adds up to more than US$100 billion in discretionary income that will be taken out of the economy.

In 2008, the emergency unemployment compensation law was passed during the depths of the recession in order to extend the normal 26 weeks of unemployment benefits that the unemployed received. The scheme has been extended numerous times since then and is set to expiry again in Jan 2013. Around three million unemployed workers are current benefitting from this program and that adds up to an estimated US$45 billion in aid that has been doled out annually. Again, cutting this scheme would slow consumer spending down especially since the unemployed would be the most prone to spend the money immediately due to their tight monetary situation.

3)   Budget Control Act

As part of the grand compromise on last year’s debt ceiling negotiations, $100 billion will be automatically cut from the federal spending budget beginning in 2013. This was because the bi-partisan “Supercommittee” that was initially tasked to find US$1.2 trillion of deficit reductions failed to find common ground, immediately triggering the Budget Control Act and its automatic spending cuts.

Conclusion

Due to the coincidental expiry of all four major programs on the same day in Jan 1, 2013, the idea of doom and gloom as portrayed by the use of the ‘fiscal cliff’ imagery has struck fear into many on Wall Street. Furthermore, apart from these four major programs, the winding down of the war in Iraq and Afghanistan will also take substantial federal spending out of the economic system over the course of 2013. Investors can only hope that both the Democrats and Republicans will finally find common ground in the next seven weeks and seek a solution that will prevent the United States from lunging into another recession.

 

Written by SiHien Goh

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