On January 1, our country will be subjected to tax increases and spending cuts that will surely send us spiraling into a recession unless something is done.
Unfortunately, we must rely on Congress to navigate us away from this fiscal cliff. Yes, the same Congress that nearly shut down the entire government last year when they couldn’t come to an agreement on the debt ceiling until the last minute. Yes, the same Congress that was in session as the United States lost its coveted AAA rating. Yes, that Congress.
However, waiting until the last minute this time may be too late.
Uncertainty regarding whether or not our economy may fall into a recession could give companies pause before they embark on that next corporate project and/or hire new employees. Conversely, if they think demand will fall substantially because of a recession or they think they may lose a key government contract, they may decide to proactively trim their workforce. Consequently, the longer Congress waits to act, the higher the chance our economy may go over the fiscal cliff before it even gets here.
The Congressional Budget Office (CBO), a nonpartisan government agency, estimates that our economy will lose $607 billion if no action is taken by Congress. This equates to about a five percent drag on our economy in the 2013 calendar year. This drag is a result of many forces, including elimination of the payroll tax cuts, expiration of the Bush-era tax cuts, automatic spending cuts from the debt ceiling debacle, and termination of extended unemployment benefits.
If the two percent payroll tax cuts are eliminated, taxes would increase by $1,000 for someone with a $50,000 salary. That’s about $20 less per week than they’re accustomed to receiving.
The Bush-era tax cuts have many provisions, such as reducing nearly everyone’s income tax bracket by 3 percent to 5 percent. More specifically, the 10 percent tax bracket goes to 15 percent, 25 percent goes to 28 percent, 33 percent goes to 36 percent, and 35 percent goes to 39.6 percent. There will also be higher taxes for dividend income and long-term capital gains. The dividend income tax rate will surge from 15 percent to whatever income tax bracket you are in, with the maximum rate being 39.6 percent. The tax rate on long-term capital gains rises from 15 percent to 20 percent. There are many more facets to these tax cuts, but these are the main items.
The automatic spending cuts from the debt ceiling debate add up to $1 trillion over the next 10 years. There is little known as to what exactly these cuts will be, except that they will be split between defense and other domestic programs.
The curtailing of unemployment benefits means that the checks coming in to support the nearly 5 million people who have been out of work for more than six months will wind down. This may encourage some people to look for work more seriously, but it will also hurt many people that are legitimately looking for work and struggling to make ends meet.
The fiscal cliff will weigh on our already fragile economy. The economic recovery from 2008 has been much slower than what everyone would like and seems to be getting even slower. The May jobs report showed that the unemployment rate rose to 8.2 percent, which was the first increase in 11 months. Also, the number of jobs added in May was at its lowest in a year, coming in at a mere 69,000. In other words, the job market is already weak, and it would not take much negative sentiment from these current levels to push job growth negative.
Focusing on the economy as a whole tells a similar story: Economic growth in the first quarter was a meager 1.9 percent, much lower than the long-term average of 3.3 percent. Moreover, economists are forecasting a paltry 2.2 percent growth rate for the second quarter and 2.3 percent growth rate for the entire year. Next year is expected to be another year of subpar growth, at around 2.5 percent.
With the economy growing slow and the job market weak, the short-term effects if Congress does not act are clear: our economy may slow in 2012 and will certainly come to a screeching halt in 2013. If nothing is done, nearly 83 percent of U.S. households will have an increase in taxes of around $3,700. With that much less to spend, corporate profits will fall because consumers aren’t buying as much and businesses will let go of some of their workers. In other words, we will be in a recession and many people will lose their jobs. This is, of course, the worst-case scenario — where the economy goes completely over the edge of the fiscal cliff.
Most pundits do not expect the worst-case scenario to play out. It is more likely that Congress will come to some sort of compromise. This compromise could be an extension of the Bush-era tax cuts for all but the most affluent households and some sort of reprieve of spending cuts — perhaps even unemployment benefits through March or later in 2013.
However, given the fact that this is an election year, it will be more difficult for something to get done in a timely fashion, because everyone will be positioning themselves and blaming the other side. Thus it is likely that any deal that gets done will come down to the last minute — again. This uncertainty will have a good chance of slowing down our economy this year but not pushing us into a recession. The uncertainty will also likely continue to make the stock market volatile as markets typically do not like the unknown.
Let’s hope Congress can actually do what’s in the best interest of our country and not what’s necessarily in their own political best interest. They are supposed to represent the people, right?
Andrew Stout, CFA, CFP® is the senior investment officer at MCF Advisors, which has offices located in Lexington and Covington.