The fiscal cliff: Now for the hard part

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The U.S. House of Representatives recently passed the American Taxpayer Relief Act (ATRA), addressing the tax portion of the fiscal cliff, but delaying decisions on the spending part for another two months (for now).

This delayed deadline now has the debate on spending coinciding with the deadline to increase the U.S. debt ceiling.

The ATRA’s accomplishments include extending the 2012 income tax rates for low- and middle-income taxpayers, and limiting the increase on capital gains and dividends. Left unaddressed are questions related to spending – the scheduled cuts to defense and discretionary spending have been deferred by two months, and the ATRA does nothing to address long-term entitlement spending problems.

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The financial markets’ focus in coming months will be split between two competing sights: a gradually improving global economy and a potentially raucous debate in the U.S. over entitlement reform and the debt ceiling. While we expect market volatility to remain elevated during the next several months, we believe the combination of moderate growth and easy monetary policy will carry the day and that portfolios should continue to be positioned for growth through tactically overweighting equities and natural resources, and underweighting investment grade bonds.

Economic policy uncertainty has been elevated over the last several years, and the arrival of the fiscal cliff presented an opportunity to add some clarity. On the tax front, important progress was made in permanently extending the Bush-era income tax rates for lower and middle-income taxpayers, while providing certainty around the tax rates on higher-income taxpayers. With respect to investment-related taxes, there was no change to the tax treatment of tax-exempt municipal bonds and qualified dividends and capital gains tax rates rose from 15 percent to 20 percent for high-income taxpayers (before the 3.8 percent Affordable Care Act tax).

Both of these are market friendly as there was building concern around the tax treatment of municipal bond income, and uncertainty around how large the increase on dividends and capital gains could be. The top gift, estate and generation-skipping transfer tax rates have permanently increased to 40 percent, with representative exclusions and exemptions set at $5 million adjusted for inflation.

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At the end of the day, the finality of the tax negotiations is a constructive step in removing some of the economic uncertainty hanging over the U.S. economy. From a growth standpoint, the permanent extension of the middle-class tax cuts eliminates the largest potential fiscal drag issue. Resumption of the full Social Security payroll tax collection and increased taxes on higher-income taxpayers will represent an approximate 1 percent fiscal drag in 2013, and implementation of the automatic spending cuts under the Budget Control Act of 2011 (sequestration) would represent further drag of around 0.8 percent of GDP. Growth will be affected in the first half of the year, but in a more manageable way than if no agreement on taxes had been reached.

Left unaddressed, however, is longer-term spending reductions. The mismatch between U.S. revenue (taxes) and spending is unsustainable at current levels, even before the upcoming increase in entitlement spending. Revenue has fluctuated between 16 percent and 21 percent of GDP throughout the last 22 years, while spending has represented between 18 percent and 25 percent of GDP.

In 2012, the Congressional Budget Office (CBO) estimates revenue of 15.7 percent of GDP, spending of 22.9 percent, and a resulting deficit of 7.2 percent. The U.S. can likely sustain a long-term fiscal deficit of 2 percent to 3 percent, meaning we need a 5 percent reduction from current levels. Federal budget accounting is a complicated matter, and in Exhibit 2 we present some alternative deficit scenarios.

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The CBO Baseline scenario, with the lowest deficits, assumes that the laws in place in 2012 continued through the study period – meaning that the Bush-era tax cuts expired and the spending sequestration occurred. Their Alternative scenario, presented to represent a more realistic outcome, assumed extension of much of 2012 policies – including continuing low tax rates and no sequestration. The deterioration in deficits over the time frame is due to increases in entitlement spending – including Social Security, Medicare and Medicaid.

Mandatory spending is projected to climb from 13.4 percent of GDP in 2013 to 14.3 percent in 2022, while discretionary spending is expected to decline to 5.6 percent of GDP by 2022 – the lowest level in 50 years. To the mix we have added two computations based on the passage of the ATRA – one assuming the sequestration (based on CBO calculations) and one without it. The latter scenario is useful to isolate what was actually agreed to in the ATRA. Looking out to 2015, the ATRA deal, without sequestration, would still leave a deficit of around $675 billion, approximately 3.8 percent of GDP, which would then deteriorate through 2022.

Passage of the ATRA is a short-term positive for the markets as it provides some needed clarity and finality on tax rates for 2013.

Unfortunately, many of the difficult decisions around spending were deferred for at least another two months and will coincide with the need to raise the U.S. debt ceiling and the expiration of the continuing resolution funding the government.

Jim McDonald is the chief investment strategist at Chicago-based Northern Trust Bank, which operates an office in downtown Milwaukee.

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