Finally…A Fiscal Cliff Deal

Magnotta@AmyLMagnotta, CFA, Brinker Capital

It went down to the wire, but the House passed the Biden-McConnell compromise late last night. Investors are cheering today, happy to have avoided the worst case scenario. While this deal reduces the scheduled fiscal drag for 2013 and eliminates a tax-rate cliff in the future, it contains no structural reforms needed to address the country’s longer-term fiscal health. In addition, it sets us up for more fiscal policy uncertainty in the first quarter.

The previously scheduled fiscal drag, estimated at 3.5% of GDP, has now been reduced to around 1.5% of GDP. A majority of the fiscal drag ($120 billion) comes from the expiration of the 2% payroll tax cut that impacts all workers, with the remainder from the tax increases on the wealthy. However, in an economy growing at a 2.6% rate, this impact of this smaller fiscal drag is not negligible.

The tax side seems to be settled for now, reducing a sharp fiscal cliff in future years. Income tax rates have been permanently extended, with tax rates increasing only on those with incomes above $400,000 ($450,000 for families). Taxes on dividends and capital gains have been increased only for taxpayers in the highest bracket, and even still rates were increased from 15% to 20% (23.8% including the tax on investment income included in the Affordable Care Act). The AMT was also patched permanently.

However, they continue to kick the can down the road on the spending side. The sequester, or the mandatory spending cuts put in place after a deal on the debt ceiling failed to materialize in 2011, has been delayed for two months. No other meaningful spending cuts were put into place. As a result, the deal adds to the deficit.

1.2.13_Magnotta_FiscalCliff_Resolution_Chart1

Source: FactSet, BEA

This deal sets up more fiscal policy uncertainty and likely more drama in the first quarter as the sequester needs to be addressed and the debt ceiling increased. The President has vowed not to negotiate over the debt ceiling. The Treasury reported that we reached the statutory debt limit on Monday, but they can continue with extraordinary measures to keep under the limit until the end of February.

With the way the fiscal cliff deal played out over the last few weeks, Washington has done little to inspire confidence that a grand bargain to address our unsustainable fiscal path can be implemented. It is clear that we need to address both the spending and revenue sides of the equation. There has been bipartisan support in the past for a tax and entitlement reform package, like the Bowles-Simpson proposal offered by the President’s own debt commission. This type of plan would increase revenues by lowering tax rates and broadening the base, and reform entitlements, setting us on a path to getting our deficits under control and bring down our debt to GDP ratio.

Without improvement in our deficit and a plan to stabilize our debt to GDP ratio, we risk another downgrade of our sovereign debt. So far, Washington has alleviated some of the near-term headwinds to economic growth, but has done very little to address our longer term problems. We can continue to hope for a less toxic political environment, but in reality, fiscal policy uncertainty will continue in 2013 and will lead to periods of increased market volatility.

1.2.13_Magnotta_FiscalCliff_Resolution_Chart2

Source: FactSet, CBO

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