‘Cliff’hanger Ending?

Americans like two things in their entertainment: tense, down-to-the wire climaxes; and sequels. Last night’s resolution to the debate surrounding the so-called fiscal cliff provided both. Several anxious hours after the “official” deadline marking the edge of the fiscal cliff, the U.S. Congress passed legislation to avert the worst of the enormous tax hikes that would have occurred as the Bush-era tax cuts of 2001 and 2003 were set to expire on January 1. The bill made it through the Senate by a vote of 89 to 8 and passed the House of Representatives with a margin of 257 to 167. Overall, the impact of the agreement is slightly friendlier than we anticipated, though still leaves room for a sequel of sorts: two more months of policy uncertainty regarding the spending side of the cliff debate (this will coincide with a likely standoff over raising the government’s debt ceiling too). We’ve written a bit more here, but theses are some of the broad strokes.

The Bush-era tax cuts were permanently extended for households with less than US$450,000 of income or individuals with less than US$400,000. For wealthier taxpayers, marginal rates on income above those points will move from 35% to 39.6%. The tax rate on dividends and capital gains will also move up, while the payroll-tax break (which hits everyone) was not extended, meaning some loss of disposable income across the board. There was also a patch to the alternative minimum tax (AMT), ensuring it would not hit a multitude of middle-income taxpayers. The other major point of the decision was that the automatic budget cuts (or “sequestration” as the policy wonks call it) that were to go into effect were delayed for two months.

Overall, we feel that there will still be a drag on economic growth in early 2013 as the economy adjusts to the higher tax rates and the comparable tax hikes that will accompany the Affordable Care and Patient Protection Act that will take effect this year. All of this suggests slower growth in the first half of the year. There could also be some potential long-term reduction in U.S. growth if the higher tax rates on capital and investment aren’t tempered with some sort of broad-based tax reform later this year or next. Further, with new spending and no budget cuts, there is no way this bill could be called “deficit reduction”; trillion-dollar deficits still loom as far as the eye can see. So while the “resolution” avoids the worst of the immediate economic drag, it sets up two months of policy uncertainty about the spending side of the budget. This likely means that financial markets will remain volatile and gains may be tempered until the debt ceiling and spending debates are resolved – hopefully in late February or early March.