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  • October 2, 2012

    Alan Levenson Alan Levenson, T. Rowe Price Chief Economist

    As we approach the presidential and congressional elections in November, investors are increasingly interested in how the election results could affect their investments. A key consideration is that a significant tightening of fiscal policy that could lead to slower economic growth—a so-called fiscal cliff—is currently scheduled to take place starting in January 2013 if Congress and the President do not agree to delay some tax increases and spending cuts. While these could have a significant impact on the economy and the financial markets, T. Rowe Price Chief Economist Alan Levenson believes that a postelection deal will be reached to delay most major tax and spending changes. Also, if an effective long-term budget deal is reached, it could prevent another U.S. credit rating downgrade and lift some of the economic uncertainty. The following represents the views of Mr. Levenson as of September 28, 2012.

    Inaction could lead to tax increases and spending cuts
    • At the end of 2012, the Bush-era tax cuts—which were previously set to expire at the end of 2010 but had been extended for two years—will lapse. The current employer payroll tax holiday will also expire.
    • The 10-year, $1.12 trillion estimated forced spending cuts authorized by the Budget Control Act of 2011—due to the failure of a bipartisan "super committee" to agree on budget cuts last November—will begin to take effect starting in January 2013.
    • Legislative provisions that have previously extended unemployment benefits, limited the reach of the federal alternative minimum tax (AMT), and prevented cuts to Medicare doctors' salaries (the so-called Doc Fix) are set to expire at the end of this year.
    Elements of the year-end fiscal cliff (2012 costs)
    Expiring Provision $ Billions % of GDP
    Extended unemployment insurance benefits 50 -0.3
    Employer payroll tax reduction 110 -0.7
    Bush-era tax cuts: upper income 50 -0.3
    Bush-era tax cuts: middle income 150 -1.0
    Budget Control Act of 2011 sequester 75 -0.5
    AMT patch 225 -1.5
    Medicare Doc Fix 30 -0.2
    Investment income (dividends and capital gains) 25 -0.2
    Estate tax 35 -0.2
    Tax extenders 65 -0.4
    Sources: Bureau of Economic Analysis, Haver Analytics, Congressional Budget Office, JPMorgan, Macroeconomic Advisers, Nomura, and T. Rowe Price.
    Could tighter fiscal policy lead to recession?
    • If the Bush-era tax cuts, employer payroll tax cut, Budget Control Act spending cuts, and unemployment benefits are allowed to expire, the result would be a tightening of fiscal policy equivalent to 2.8% of gross domestic product (GDP) in calendar year 2013.
    • If the so-called AMT patch and Doc Fix provisions are also allowed to expire, the fiscal impact on GDP would be even greater. "But Congress has been rolling these over for years," says Mr. Levenson, "so I consider them to be subject to less uncertainty."
    • While very few economists are predicting a U.S. recession starting in the first quarter of 2013, if all of these budget cuts and tax increases are allowed to take effect, it would represent a key risk to the U.S. economic growth outlook.
    A postelection budget deal is likely
    • Given the potential impact of tighter fiscal policy on the economy, Congress and the President will likely reach an agreement to postpone major cuts in government spending and extend some of the Bush-era tax cuts.
    • That does not necessarily mean that all tax rates will remain where they are today. The employer payroll tax cut, the extension of unemployment benefits, and the Bush-era tax cuts for upper-income individuals will likely be allowed to expire. The other provisions in the table above might be extended for some period of time.
    • While delayed spending cuts and tax increases would prevent a near-term hit to the economy, the federal government's revenues and expenditures would go further away from alignment. "Failing to address the underlying imbalance between the projected paths of entitlement spending and the stream of revenue to pay for entitlements would leave the federal government's budget on an unsustainable path," says Mr. Levenson.
    Quick and effective action could stave off another downgrade and lift the economy
    • Regardless of the election results, the President and Congress will have limited time to implement a long-term plan for fiscal sustainability. In July, Fitch reaffirmed its AAA credit rating of U.S. sovereign debt but warned that a government failure to formulate a deficit reduction plan by late 2013 will likely lead to a ratings downgrade.
    • An effective compromise to curb budget deficits and stabilize the national debt would consist of both raising revenue and reducing spending, which could occur through entitlement reform, reducing certain popular deductions, and adjusting tax rates.
    • Due to macroeconomic uncertainty stemming from the approaching fiscal cliff, businesses have been reluctant to expand and hire and have delayed investments in new technologies or capital equipment. However, a plan for long-term budget sustainability could provide an immediate boost to the economy by increasing optimism among businesses and investors.
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