December 14, 2012
|T. Rowe Price economists Alan Levenson and Jared Franz|
As we approach the end of 2012, investors are becoming increasingly anxious that a deal to avoid or lessen the impact of the fiscal cliff will not be reached before January 1, 2013. Although negotiations between Republican leaders in the House of Representatives and President Obama are currently at a standstill, T. Rowe Price economists Jared Franz and Alan Levenson believe that a fiscal cliff compromise—though probably not a "grand bargain" that also addresses long-term deficit reduction—will be reached by the end of the year and could include an increase in the U.S. debt limit. If no compromise is reached by year-end, the tax measures and spending cuts will take effect at once, but according to our economists' analysis, they will have diffused impacts on the economy. The following reflects their views as of December 13, 2012.
As the December 31 deadline approaches for avoiding the fiscal cliff, negotiations encompass two distinct but related issues: avoiding the bulk of the fiscal cliff tax increases and spending cuts and achieving a "grand bargain" on long-term deficit reduction that saves at least $3 trillion over 10 years. We expect a compromise to emerge that will avoid the fiscal cliff, but we think it is unlikely to come as part of a broader agreement on revenue-increasing structural tax reform and expenditure-reducing structural entitlement reform—both of which are required, in our opinion, to put the country's finances on a sustainable long-term path. A best-case scenario would be a fiscal cliff compromise to avoid excessive near-term fiscal tightening, accompanied by a framework for long-term deficit reduction, perhaps including specific revenue and expenditure targets.
The Bipartisan Policy Center estimates that the U.S. Treasury will reach the statutory debt limit in the last week of December but that "extraordinary measures" amounting to $197 billion could push this date to late February 2013.* Seeking to avoid another debt-ceiling showdown (like in summer 2011) on the heels of a fiscal cliff compromise, Democrats recently pushed for inclusion of a debt-ceiling increase along with such a compromise. Since the U.S. runs budget deficits of roughly $1 trillion per year, a two-year extension to get through the November 2014 election would require a $2 trillion increase in the debt ceiling.
Of course, President Obama and the lame-duck Congress could remain at loggerheads, driving the economy fully off the fiscal cliff, unleashing a fiscal drag equivalent to 4.4% of gross domestic product (GDP), as shown in the table below.
|Elements of the Year-End Fiscal Cliff|
|Expiring Provision||Cost ($ billions)||Percent of GDP||Potential Avoidance Mechanism|
|Bush-era tax cuts: upper income1||89||0.6||Freeze withholding tables|
|Bush-era tax cuts: middle income1||135||0.9||Freeze withholding tables|
|2% payroll tax holiday||85||0.6||None if not renewed|
|Extended federal unemployment insurance||34||0.2||None if not renewed|
|Budget Control Act of 2011 sequester||65||0.4||Office of Management and Budget apportionment|
|Caps on discretionary appropriations2||75||0.5||Unlikely to be changed|
|AMT3 patch||88||0.5||No impact until March 2013|
|Business and other tax extenders4||89||0.6||No impact until 2014|
|Medicare "doc fix"5||12||0.1||None|
|Taxes included in the Affordable Care Act||18||0.1||None|
2 Caps on discretionary appropriations, restraining discretionary spending to a rate below inflation, were put in place as part of the Budget Control Act of 2011. The 10-year, $1.2 trillion across-the-board sequester triggered by the failure of the super committee to approve a 10-year, $1.2 trillion (minimum) deficit-reduction deal is applied on top of this capped spending level.
3 Alternative minimum tax.
4 A collection of "about 80 provisions, many of which expired at the end of December 2011. Nearly all of those provisions also had been extended previously; some, such as the research and experimentation tax credit, more than once." ("An Update to the Budget and Economic Outlook: Fiscal Years 2012–2022," Congressional Budget Office, August 22, 2012, p. 19.)
5 Preventing a scheduled 27% drop in Medicare's payment rates for physicians' services.
Sources: Congressional Budget Office and T. Rowe Price. Components do not sum to totals due to rounding.
While all of these measures would take effect at the same time, their effects on the economy would be spread out or, in some cases, could be delayed by executive action not requiring legislative approval:
- Bush-era tax cuts. Even if lawmakers do not stop the scheduled January 1, 2013, increase in tax rates, the president could authorize the IRS to freeze withholding tax tables to reflect the lower 2012 rates.
- Across-the-board sequestration. Even if the budget cuts triggered by the failure of a Congressional super committee to reach a $1.2 trillion deficit-reduction deal in November 2011 take effect, the president could direct the Office of Management and Budget to apportion money appropriated to various agencies to spend as if the sequester were not in effect.
- Alternative minimum tax. Tax liabilities incurred under an "un-patched" AMT would not be due until April 2013. To this point, IRS Acting Commissioner Steven T. Miller has directed the agency to assume the AMT gets patched before year-end for the 2012 tax year.**
- Business and other tax "extenders." Liabilities incurred if this $89 billion potpourri of tax provisions is not renewed would be due during the course of the 2013 tax year, running into April 2014.
Even if the first-order effects of these elements of the fiscal cliff are tempered along the lines just described, market sentiment and private sector decision-making would likely be impaired by Congress's failure to agree on fiscal policy.
**Acting IRS Commissioner Miller's letter to Senator Orrin Hatch, November 13, 2012.