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The CBO report identifies eight elements of this looming fiscal drag: five automatic tax hikes and three automatic spending cuts. It estimates their total impact for fiscal 2013 at $607 billion, or some 4.0% of the country’s gross domestic product (GDP), and enough to turn positive growth negative.
Scheduled tax hikes amount to $399 billion, some two-thirds of the total effect. These include $221 billion from the expiration of the Bush tax cuts and last year’s decision not to limit the reach of the alternative minimum tax (AMT). The AMT matter actually applies to 2012 earnings, but will burden taxpayers’ cash flows only after they calculate their full liability in 2013. Also scheduled is an automatic $95 billion tax hike from the expiration of the 2 percentage-point payroll tax holiday; a $65 billion tax increase from the expiration of rules allowing businesses to expense investment property; and an $18 billion hike, built into 2010’s “Obamacare” legislation, on the earnings of high-income taxpayers.
On the spending side, there are $208 billion in cuts and scheduled fee increases. These include the so-called sequestration of discretionary spending. Mandated by the Budget Control Act that emerged last year from the debt ceiling debate, this would cut some $65 billion out of federal spending for the year. The end of extended unemployment benefits, according to the CBO, should cut $26 billion out of the year’s spending, and the scheduled reduction in payments to doctors under Medicare should cut another $11 billion out of spending. A large number of smaller items, also scheduled to go into effect in 2013, sum to an additional $105 billion in spending restraint.
If allowed to go forward, the CBO estimates that this fiscal restraint would precipitate a recession in the first half of 2013, with the nation’s real GDP dropping at an annual rate of 1.3%. A modest recovery during the second half would allow 2013, by CBO calculations, to produce a mere 0.5% growth for the year as a whole. This projection contrasts with an earlier CBO forecast of 1.1% real GDP growth in 2013.
Since even Congress cannot ignore such a dire prospect, probabilities are that representatives and senators will take action to stop or postpone these otherwise automatic effects. Doubtless, they will wait for a lame-duck session after the election. The give and take of compromise on these points is much too politically explosive for any of them to deal with before election day. But afterward, later in November and in December, there will be ample time for Washington to generate at least a temporary fix to avoid driving the economy off this “fiscal cliff.”
Congress can easily postpone the spending cuts otherwise scheduled. Last year’s Budget Control Act is, after all, a product of Congress and subject to its subsequent votes. Congress could easily push sequestration out for at least a year and perhaps indefinitely. Similarly, they should have little trouble postponing the reduction in doctors’ payments. This postponement has become an annual event, in fact, so regular that it has acquired the nickname of the “doc fix.” Similarly, Congress should have little difficulty softening the end of extended unemployment benefits. They were part of a fiscal compromise in 2010. A gradual decay in the amount of required spending seems a plausible approach.
The tax side is more complex, but not insurmountable. The parties are farthest apart on the expiration of the Bush tax cuts. Democrats want to continue the tax relief only for those individuals who make less than $200,000 a year and those couples who make less than $250,000 a year. Republicans want to continue the tax relief for all income levels. Since all the tax relief would otherwise disappear automatically, the Republicans will threaten, as they did when this came up in 2010, to vote down anything but complete renewal.
Despite the appearance here of an impasse, tax reform might offer a way out. Both Republicans and Democrats during recent years have proposed reforms that would reduce the statutory rate and broaden the tax base by eliminating tax breaks and credits. These could appeal, especially when neither party has the luxury of inaction. A reform effort would enable either party to sidestep AMT and Obamacare tax matters. Because of the impasse over the Bush tax cuts, reform also would enable both parties to avoid the label of tax increases. For Republicans, reform would further appeal by offering elements of the growth-oriented tax efficiencies that the party has embraced in the past, most recently in the so-called Ryan plan (named after Congressman Paul Ryan [R-WI]). Republicans might even allow a net tax increase if associated with reforms that would allow them to offer their constituents a drop in the statutory rate. For the Democrats, tax reforms would allow them to sidestep accusations of class warfare and also avoid the risk that an impasse would force tax hikes upon their constituencies at the lower end of the income distribution. They also would embrace the broadening, since, rhetoric aside, they know that tax hikes on the wealthy alone cannot close the budget gap.
More cynically, discussion of reform, even if Congress is still far from agreement, could serve as an excuse to avoid the “cliff.” Both sides could claim that they will accept a simple continuation current law for some months or a year in order to work out the details of more serious and lasting tax reform. It would at least avoid the appearance of kicking the can down the road, and, if sincere, it might actually give the country a more efficient, simpler, more growth-oriented tax code. If, however, there is partisan posing to avoid a difficult vote, the economy could at least avoid driving off the “fiscal cliff.” In either case, the recovery misses the downside, which the CBO has detailed, and the economy will continue its otherwise plodding recovery.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.