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How 'Fiscal Cliff” Would Impact Economy

 December 02, 2012 09:16 PM


(By Mani) The term "fiscal cliff" has weighed on the stock market for the past few days. President Barack Obama has pushed for higher taxes on wealthy Americans to address the "fiscal cliff" of roughly $600 billion in spending cuts and tax increases that could hit economic growth.

Included in the fiscal cliff debate are the following tax provisions as summarized by the Congressional Research Service:

• Bush-era tax cuts reduced income taxes through lower across-the-board rates, reduced the marriage penalty, repealed limitations on personal exemptions and itemized deductions, expanded refundable credits, and modified education tax incentives. In addition, the Bush-era tax cuts reduced estate taxes by increasing the amount of an estate exempt from taxation and by lowering the estate tax rate.

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• The patch for the Alternative Minimum Tax, or AMT, which increased the amount of income that is exempt from the AMT, and allows certain personal credits against the AMT that prevents an estimated 26 million additional taxpayers from being subject to the AMT.

• Tax credits and deductions (known as tax "extenders") that affect individuals, businesses, charitable giving, energy, community development, and disaster relief.

In addition to the expiring tax provisions above, $1.2 trillion in automatic cuts to federal spending (known as sequestration) over the next 10 years would go into effect per the Budget Control Act of 2011.

"In the event that Congress and the president allow current law to go into effect next year, the result would be a recession beginning in early 2013. We now expect that going over the fiscal cliff would result in economic growth for 2013 declining 0.2 percent for the year, as a technical recession would begin in the first quarter of 2013 and likely extend through the third quarter of 2013," Wells Fargo economist John Silvia wrote in a note to clients.

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Consumer demand could slow immediately after going over the fiscal cliff as a result of the large increase in taxes, dramatically reducing after-tax income. In addition, business spending and thus employment growth would grind to a halt as businesses brace for a recession.

The sharp pullback in consumer spending in the first quarter would result in positive inventory building, which would have the effect of reducing the drag on second-quarter growth.

Over the entire 2013 period, government spending cuts would sharply subtract from headline GDP growth as the federal government would pare back spending and budget pressures could re-emerge at the state and local level from reduced sales and income tax collections and cuts to federal grant programs.

While the most severe effects from the fiscal cliff would be realized in 2013, there would be some spillover effects into early 2014, especially from cuts to government spending.

"Currently, our forecast for economic growth in the fourth quarter of 2013 is for 2.2 percent annualized growth," Silvia said.

The Budget Control Act (BCA) will impose automatic spending cuts to defense spending totaling $24 billion for 2013. Due to the extent to which defense spending contributes directly and indirectly through other industries, notably manufacturing, to the economy, the reduction of such spending could have large ripple effects.

"If policymakers do not eliminate these automatic spending cuts, GDP growth would be further reduced by 0.4 percentage points in the fourth quarter of 2013," Silvia noted.

Similarly, maintaining the automatic reductions to non-defense spending as specified in the BCA along with Medicare's payment rate for physicians could subtract an additional 0.4 percentage point from real GDP in the fourth quarter.

Therefore, eliminating the automatic spending cuts, both discretionary and non-discretionary that were imposed by the BCA provides 0.8 percentage points to economic growth in the last quarter of next year.

Meanwhile, the tax provisions enacted over the past decade, including the ones that were originally set to expire in 2011, helped pad the wallets of consumers during the recovery. Consumer spending accounts for around 70 percent of GDP, therefore, at a time when the economy is struggling to gain momentum such relief on the consumer supports economic growth.

"If policymakers were to eliminate most expiring tax provisions, excluding the payroll tax relief that has been in effect since January 2011, and furthermore, decide not to index the Alternative Minimum Tax for inflation, such measures would detract 1.4 percentage points from real GDP growth in the fourth quarter of next year," Silvia said.

"Moreover, if we wish not to extend tax breaks for higher income individuals, the economy will still receive a 1.3 percentage point hit to economic growth," he added.

Maintaining the existing law, where all of the tax cuts expire and the sequestration goes into effect, would have a significant impact on economic growth, bringing the estimated 2.2 percent baseline economic growth rate for the fourth quarter of 2013 to an abysmal 0.0 percent rate.

The severity of this outcome re-enforces the need for policymakers on both sides of the aisle to step up and make tough decisions about the future of tax policy and federal spending, especially spending on entitlement programs.

"The faster Congress and the administration address these challenges the sooner the U.S. economy can begin to slowly return to trend growth," Silvia noted.

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