Orlando's Outlook: Watch out for that fiscal cliff!

Bottom Line In the immediate wake of the best first quarter since 1998, in which the S&P 500 rallied by a powerful 12%, investors have  given back most of those gains over the past two months, with stocks down almost 9%. Of immediate concern, of course, is the intensifying sovereign-debt crisis in Europe, as the stunning and inconclusive May 6 election results in Greece have heightened the prospect of that country both defaulting on its debt and being forced from the eurozone, perhaps sparking a domino effect that may cascade through Portugal, Spain and Italy. But the market’s longer-term concern is the looming fiscal cliff here at home, the combination of forced tax hikes and spending cuts that automatically take effect at year end, and which could push the U.S. economy back into recession. We can drive a truck through the wide range of opinion on Wall Street, with optimists suggesting the hit to Gross Domestic Product (GDP) might be about 1%, while the pessimists point to a much more draconian 5% collapse. Regardless, our forecast for next year has been for above-consensus but below-trend GDP growth of 2.9%, with the expectation that a favorable election in November will result in either a lame-duck or beginning-of-the-year compromise to avert the dreaded fiscal cliff. But if it turns out that we’re wrong, and that we don’t elect the right people in November, and if they don’t defuse this ticking fiscal time bomb in a timely fashion, then regrettably, a recession forecast for 2013 could become a very real possibility.   

CBO sets the table All of this was supposed to be fixed, of course, with last summer’s “Grand Bargain” between President Obama and House Speaker John Boehner. The backstop to their failure was the Congressional Super Committee’s three-month deliberations last fall, which also failed. So given the status of a rudderless Washington, the Congressional Budget Office (CBO) weighed in this week. They estimated that if the Bush tax cuts and all other temporary tax-relief measures were allowed to expire at year’s end under current law, and if the 2013 sequester (automatic spending cuts) adopted when last year’s Super Committee failed to reach a deficit-cutting deal takes effect, the economy would confront an estimated $600 billion of annual tax increases and spending cuts next year. That would represent a potential 3-4% hit to GDP in calendar 2013, with the rate of unemployment rising from 8.1% currently to 9.2%, pushing the economy back into recession, with real GDP shrinking by an estimated 1.3% in next year’s first half. In contrast, however, the CBO estimates that if all the tax cuts were maintained and the spending cuts were put off, GDP would grow by 4.4% next year, and the economy would add an estimated two million jobs.  

Bush tax cuts are the big ticket Item Much of the coming fight will center on what to do about the 2001 and 2003 temporary tax cuts enacted under former President George W. Bush. The combined tax cuts are estimated to total just north of $200 billion a year, and neither party appears willing to roll them back to their earlier levels on everyone. But President Obama and most Democrats insist on allowing the tax cuts to expire for the “rich”—which they define as individuals who earn more than $200,000 or households earning $250,000 and up. They propose restoring the maximum marginal tax rate to 39.6% from the current 35%, and adding a 3.8% health-care tax premium on unearned income, as well as lifting the maximum capital gains tax rate to 20% from 15% and the dividend tax rate to 39.6%. Republicans favor making the Bush cuts permanent for everyone. Economists believe that most of the potential fiscal policy drag on GDP would come from this proposed hike in tax rates.

Alternative Minimum Tax (AMT) & the Buffet Rule The AMT sets a minimum tax rate of about 28% on income above a certain exempted level to make sure upper-income households with a high number of deductions still pay a minimum level of taxes. But the tax code does not index exempted incomes for inflation, so a growing number of middle-income households found themselves hit by this tax in the past decade, prompting Congress to adopt an annual “ATM patch’’ that adjusts the minimums to eliminate this so-called “bracket creep.’’ If it doesn’t adopt a patch this year, the exempted income threshold for married couples filing jointly would fall to $45,000 from last year’s $75,000—a tax increase totaling an estimated $38 billion, according to Washington Analysis. Alternatively, the president is proposing the so-called “Buffet Rule” to replace the AMT, which would establish a minimum 30% tax for individuals with $1 million or more in annual income, from their very first taxable dollar, with no benefit of deductions.

Payroll tax holiday Also on the table is the two percentage-point reduction in the Social Security payroll tax on employees enacted in 2010 and extended through this year. But an extension of the Social Security payroll tax hurts Social Security funding.

Extended unemployment benefits Unemployment insurance was recently extended through year end 2012, but the maximum length of the benefits was reduced from 99 weeks to 79 weeks. Because many economists believe that the extended benefits actually serve as a deterrent for those who are out of work to seek new employment, we may see the maximum length of benefits shrink back to more traditional metrics. 

Sequester and defense spending Along with the Bush tax cuts, this is the biggest ideological battle ground. Almost as quickly as they signed off on the defense cuts included in the Super Committee sequester (cuts were roughly split between defense and non-defense discretionary outlays), Republicans—and some Democrats—have been looking to undo much of them, focusing instead on making more cuts to social programs such as foods stamps and Medicaid. Even Defense Secretary Leon Panetta believes that the proposed cuts in defense spending are simply too extreme, leaving the U.S. militarily vulnerable.  

Another debt ceiling looms Complicating all of this, the Treasury Department reports that the U.S. government will hit its current $16.394 trillion borrowing limit, perhaps by year end, although Treasury says it can take steps to forestall default until sometime in early 2013. House Speaker Boehner has laid down the rhetorical gauntlet, saying that any increases in the nation’s borrowing limit (debt ceiling) must be paid for with spending cuts and other budget savings—and not tax rate increases, which he insists are off the table.

Commence more can kicking? As we saw with last spring’s showdown over the debt ceiling and later with the utter failure of the Grand Bargain and the Super Committee, compromise is a very dirty word in Washington these days. It may simply be easier to kick the proverbial can down the road—yet again—by effectively keeping everything as it is until mid-2013, when the election’s outcome is known, and our newly constituted Washington can begin the process of making the hard and necessary decisions surrounding tax and entitlement reform. All of this points to an uncertain summer for investors.