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As of this writing, just days before the world tests the Mayan thesis, the negotiations in Washington revolve around three elements. Republicans, who originally wanted to cut entitlements spending and preserve lower tax rates for all, have made concessions, proposing cuts in entitlements spending (though hardly fundamental reform), an increase in the debt ceiling, and tax rate increases, but only on those who earn more than $1.0 million a year. President Obama, who originally wanted to wait on spending cuts and preserve lower tax rates only for single people who earn $200,000 or less per year and couples who earn $250,000 or less a year, has countered, proposing to raise the income threshold to $400,000 before tax rate increases kick in. The president also proposed entitlements spending cuts similar to the Republicans, including an adjustment in the way Social Security calculates cost-of-living increases. With these concessions setting the stage for each side to yield a little more, the Republicans, under House Speaker John Boehner, then announced a backup plan, should the negotiations with the president fail. It would wait on entitlements spending cuts, keep the $1.0 million income limit for any tax rate increases, and shift the burden of the sequestered spending away from defense.
If the president and Congress continue their negotiations along the lines drawn in the proposals and counter proposals, the nation will likely avoid the bulk of the fiscal cliff and so also recession. The expiration of the Bush tax rates is the biggest aspect of the cliff. Especially in the Republican proposal, most taxpayers in such a compromise would keep lower rates than if the law simply were to expire. Even if the president were to get a significantly lower income threshold for tax hikes, still the majority would retain what they have. Meanwhile, entitlements spending cuts, whatever their exact configuration, would allow Washington to avoid the sequestration of funds demanded by the 2011 debt ceiling compromise. Combined, these two measures would reduce the cliff's size by more than half. Especially if such an agreement also forestalled another debt ceiling debate, it also could likely keep the credit rating agencies from downgrading the United States again.
With such negotiations done, or even a Republican alternative in place, Congress should also have little difficulty dispensing with two other pieces of the cliff. One is the scheduled 27% cut in the doctor's fees paid by Medicare and Medicaid. This is nothing new. It has been scheduled for years now, and each year Washington has passed special legislation to postpone it. The postponement has become so common that Congress calls it by its nickname, the "doc fix." Congress in such a setting also could quickly pass its annual effort to prevent an expansion of alternative minimum tax (AMT) burdens. This annual fix, called the "AMT patch," has for years kept this burden from expanding from about four million wealthy people into the middle class and affecting some 32 million. Because Congress has not yet passed this patch for 2012, a failure to act could shock a great number of taxpayers as they prepare their 2012 returns this March and April. But out from under the negotiating pressure of the cliff, there is every reason to expect them to act expeditiously to avoid this shock.
The remainder of the cliff lies largely in the scheduled cancellation of extended unemployment benefits and the partial payroll tax holiday. The latter is the more significant of the two. If the tax holiday were to end suddenly, wage earners in aggregate would lose, at a minimum, $3.0 billion a week in spendable income. Such a shock would doubtless retard consumer spending, especially in January, when it would first hit take-home pay. But the impact would moderate significantly if, as Congress has discussed, this tax holiday were phased out gradually over one or two years. Even its full force, as problematic as it could be initially, especially for lower-income people, would not in itself bring on the recession. As for extended unemployment insurance payments, their significance to the economy has already fallen by more than half since 2010. Flows to individuals in this program, once as much as 1.2% of total personal income, stand now at merely 0.5%. This bit of fiscal restraint, especially if phased out over a year or two, would have little macro effect.
Even if negotiations break down and the new year arrives without a deal, Washington will still have time to avoid a recession. The $600-plus billion in automatic tax hikes and spending cuts that constitute the fiscal cliff will not have their effect all at once on January 2. Rather, the adverse economic effects will build gradually. The recessionary impact will reflect a cumulative effect over time. If, having failed in December, the president and Congress can get their act together in January or February and arrive at a compromise, the cumulative effect in the interim will likely be insufficient to precipitate recession. But each week into the new year without a solution only adds to the adverse weight on the economy. By March, the recessionary forces, outlined so well by the Congressional Budget Office, might become too much to reverse.
Much, clearly, remains up in the air. Failure in these negotiations is not yet a foregone conclusion, though it is already a great disappointment that Washington again has failed even to begin to address fundamental budget concerns. There is reason to hope, at this writing, that the economy will still avoid the worst of the fiscal cliff, either in a deal before year-end or in early 2013. But, then, Washington could fail—and it would not be the first time. There also is hope, given the promises to revisit tax and entitlements reform, that in the next few months Congress and the president will actually start talking about fundamental measures. History, however, suggests that investors and taxpayers also curb their enthusiasm on this front.
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.