One of the major risks facing the U.S. economy and markets as we enter the final months of 2012 is the fiscal cliff. The amount of expiring tax provisions and spending cuts is estimated to be over 3% of Gross Domestic Product (GDP), and with economic growth running below 2%, the fiscal cliff will put us into a recession.*
There will be no resolution on the fiscal cliff until after the election. However, we are hopeful that a short-term extension of many of the policies will be agreed upon in the lame duck session of Congress. Some fiscal drag is likely – for example, neither party is in favor of extending the 2% payroll tax cut – but it should be closer to 1% of GDP.
One of the key tax provisions Congress needs to address this year is the Alternative Minimum Tax (AMT). The current AMT patch expired in 2011, so it can only be retroactively fixed in 2012. If not remedied, 30 million Americans with annual incomes of about $50,000 will get hit with the AMT when they file their taxes in early 2013. This would be a political and economic disaster, and as a result may act as a catalyst for a short-term deal.
In addition, the debt ceiling must be raised soon. In a lame duck session, the Democrat-controlled Senate may agree to extension of all of the Bush tax rates for an increase in the debt ceiling, especially if President Obama is reelected.
While a short-term deal would again kick the can down the road, it will hopefully set us up for a real tax and entitlement reform package in 2013. We don’t have any other option – our fiscal situation demands real reforms as our current path is unsustainable. The specific path we take will depend on the outcome of November’s election, but regardless, our approach will have to address both the spending and revenue sides of the equation, as well as entitlement programs.
We currently have the luxury of being the beneficiary of the global flight to safety so our borrowing costs are extremely low. How long can that continue? We should take advantage and make the reforms before the market forces our hand as we are now seeing in Europe. The environment in Washington does not inspire confidence; however, lawmakers have little choice when faced with our fiscal reality. Let’s just hope they focus more on effective policy and setting us on the right long-term path, and less on their short-term reelection concerns.
The following charts from Dan Clifton, Head of Policy Research at Strategas Research Partners, tell the story. The real work must be done in 2013.
*Source: Strategas Research Partners