The odds of a deal in Washington before year-end have increased as conversations between President Obama and Speaker Boehner have become more serious since Sunday. There has not been any public discussion of the negotiations, which is a positive sign. With less than three weeks left in the year, we need to see major progress soon, allowing for enough time to draft and vote on legislation before Congress leaves Washington for the Christmas holiday.
The highest probability outcome remains that a short-term deal is agreed on that serves as a down payment on tax and entitlement reform in 2013. This deal will include the framework for increased tax revenues and spending cuts, as well as an increase in the debt ceiling, which we feel will result in a fiscal drag of closer to 1% of GDP in 2013. It is our belief that this type of deal would be a positive for markets and confidence.
If time runs out on a larger deal, the House could pass a bill that maintains all of the current tax rates for those with incomes below $200,000, raises the capital gains and dividend taxes to 20%, and patches the Alternative Minimum Tax. However, the fiscal drag under this option is significantly higher than consensus. In addition, the brinkmanship would continue as the debt ceiling would have to be dealt with in early 2013.
The final potential outcome is that no deal can be reached and we go off the cliff completely. While we believe this is a lower probability event, it remains a risk. The markets would likely react negatively as the resulting fiscal drag would be greater than expected, and there would be a lack of confidence that Washington is serious about getting a handle on our long-term fiscal issues.
One big catalyst that should force both parties to reach a deal before year-end is that the Alternative Minimum Tax (AMT) patch expired at the end of 2011 and needs to be extended for this calendar year. If the AMT is not patched there will be a significant increase in the number taxpayers who are impacted, shifting the burden into the middle class. According to the Tax Policy Center, under current law if Congress does not act, the percentage of taxpayers affected by the AMT will increase from 4% to 32%. This increased tax bill would be a hit to consumers and a significant negative for growth in the first half of 2012.
A deal on the fiscal cliff could restore some confidence that both parties in Washington can compromise on policy and are serious about setting us on a sustainable, long-term fiscal path. Some level of certainty on a deal could also boost business confidence, and as a result, investment and economic growth.
Follow Amy on Twitter @AmyLMagnotta.