Scaling the Fiscal Cliff
Sorting out the Potential Impact of Impending Changes in U.S. Taxes and Government Spending in January 2013 May Hinge as Much on Election-year Politics as on Economics


July 2012

Congress' ability to agree on how to scale the so-called "fiscal cliff" could wind up as a last-minute stopgap effort driven as much by the outcome of November's U.S. presidential election as by its economic merits, forecasters say.

But unless Congress acts soon to stop automatic government spending reductions and expiration of long-standing tax cuts that would slash the federal budget deficit, forecasters fear the U.S. economy could slip back into recession next year.

Fiscal cliff is a term used to describe the possible impact from the sharp reduction of the federal budget deficit, which the Congressional Budget Office (CBO) estimates will shrink to $612 billion in fiscal 2013 from $1.17 trillion in fiscal 2012. According to the CBO's calculations, the federal budget deficit as a percentage of gross domestic product (GDP) would stand at 3.8% of GDP in 2013 versus 7.6% of GDP in 2012 — the largest reduction during a single fiscal year in the entire post-war period.

As a result of the large decline in the budget deficit, for instance, the CBO estimates that real GDP would drop 1.3% in the first half of 2013 and register a 2.3% increase in the second half of 2013, with the real GDP in calendar year 2013 posting only a 0.5% increase.

However, the CBO's estimates overlook one of the key unknowns in the equation: November's elections. "The CBO's forecast does not incorporate the outcome of U.S. elections in November, an important game-changer," says Asha Bangalore, economist and senior vice president at Northern Trust. "Aspects of the current law are bound to be retained, diluted or modified, depending on not only who is president but also by the composition of both the House and Senate."

By contrast, she notes that the CBO, private sector and Federal Reserve predictions of real GDP growth in 2013 are markedly different, possibly because the private sector and Fed may be partially discounting the ramifications of the current law. The Fed's June 2012 projections show economic growth of 2.2%–2.8% in 2013 on a fourth-quarter to fourth-quarter basis. The June 2012 Blue Chip consensus of economists calls for a 2.4% increase in real GDP for 2013. The current Northern Trust forecast of a 3.1% increase in real GDP during 2013 is tied to the performance of bank credit.

In particular, Bangalore says if President Obama is re-elected, the prospect of a partial expiration of income tax cuts — particularly that of wealthy households — is high. However, if Mitt Romney wins the election, it seems likely that the personal income tax cuts in place will be made a permanent feature of the tax code.

"Ultimately, the income tax component of current law is subject to the political fortunes of the two parties and, thus, current projections will have to be revised after the elections, as the possible directions it may take are far too many," she adds.

 
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