March 26, 2012
Heard the One About a "Fiscal Cliff"?
Brian S. Wesbury - Chief Economist
Robert Stein - Senior Economist
Date: 3/26/2012
For three years the market has
suffered from a severe case of economic hypochondria. Headline after
headline proclaimed that this time, for sure, the recession would
return. Remember Dubai and Tunisia? What about deleveraging,
re-setting adjustable rate mortgages, credit-default-swaps, foreclosures,
Greece, state and local budget cuts, rising energy prices, the debt ceiling,
unemployment, the Super Committee, or the S&P downgrade? All of these
have come and gone…and yet the recovery is three years old.
Now, some doomsayers are pointing
ahead to a "fiscal cliff” in 2013. The supposed cliff is a combination of
possible policy changes all happening next year. These include the sunset
of the "Bush tax cuts” (on regular income, dividends, capital gains, and
estates), the end of the payroll tax cut, and the planned cuts to federal
spending.
The theory is that the combination
of higher taxes and lower spending will push our economy right back into
recession. We don’t think this is going to happen and investors should not
waste time worrying about it. First, regardless of the outcome of the presidential
election, we think the most likely policy result is a continuation of most, if
not all, of the Bush tax rates, at least through the end of 2014.
If a Republican wins the White
House, they are also likely to control the House and Senate. This would
allow them to keep those lower tax rates (or cut them even further!) with
simple majorities, through the budget reconciliation process. In other
words, they would not need Democrat votes.
If President Obama wins re-election,
he may want to end the lower tax rates on regular income, dividends, and
capital gains for high-income taxpayers. But the Republicans would likely
retain the House, and so Obama could not extend the tax cuts for the middle
class unless he capitulated on extending them for everyone. His advisors,
with their eyes then moving toward the 2014 elections, will tell him to extend
those tax cuts one more time, just like they did back in 2010.
Worst case scenario: we go back to
the tax rates we had under President Clinton. This would hurt the economy,
but for many reasons investors should ignore this unlikely scenario for
now.
By contrast, the end of the payroll
tax cut is likely. Neither side really likes this policy. Conservatives
argue that it’s temporary and it’s not really a cut at the
margin. Liberals worry that cutting payroll taxes severs the link between
worker "contributions” and future benefits, which could ultimately undermine
political support for the Social Security
program.
From an economic point of view,
ending the break will not significantly alter the course of the
economy. Personal saving is now running at an annual rate of about $540
billion. Returning the tax rate to 6.2% would cost workers about $120
billion per year. Given that personal saving hovered around $270 billion
per year from the early 1980s through 2007, the loss of the tax cut can be more
than made up for by reduced savings. History suggests the economy will
survive.
The least of our worries is the
scheduled slowdown in federal spending. We don’t see how the economy gets
on a truly sustainable growth path without a significant decline in federal
spending relative to GDP. What would worry us more is if politicians found
a way to wiggle out of their promises and spending continued on its unsustainable
growth trend.
Bottom line: expect to hear more
about the "fiscal cliff” for the next several months. Then, when it
doesn’t cause a recession, you’ll never hear about it again.