PORTFOLIO POINT: Any fall over the US fiscal cliff, if it happens, will be softened by the expiry of tax cuts, reduced savings rates, and minimal cuts in government spending.
Jim Rogers, the renowned investor who with George Soros established the Quantum Fund back in the 1970s, captures the concerns of many global investors when he suggests the US is headed toward an unavoidable recession.
The cause? The looming fiscal cliff. The Wall Street Journal notes it is the key risk identified by European investors.
So far I’ve been fairly quiet on the issue, but this week I want to investigate the coming fiscal cliff and try and get a handle on what is going on exactly. How severe it could be, and what that means for investors.
Many readers probably already know the general gist, but for those who don’t, the fiscal cliff represents the automatic deficit reduction plans that were passed by Congress in the Budget Control Act of August 2011. In that act, it was determined that by November 2012, a Joint Select Committee must produce bipartisan legislation to cut the deficit by $1.2 trillion over the next 10 years. If they failed to agree, an automatic across-the-board deficit reduction plan would be implemented in early 2013.
If the automatic deficit reduction plan is implemented, the US Congressional Budget office (which is a bipartisan office), estimates that, the deficit, currently estimated at 7.3% this year (from 8.7% last year) would drop to 4.0% in 2013.
At face value this represents a significant contractionary influence on GDP – of about 3.3% (4% minus 7.3%) - and that’s got everyone spooked. Unlike a lot of stories going around though, this one isn’t irrational – it’s backed by very solid economic theory and, of course, historical experience.
I mean, think of it this way. If we start 2013 3.3% in the red, you’d obviously need a substantial lift in private demand to offset that. In this case you’d need private demand growth of nearly 6% to bring the economy back to trend. No easy task, especially considering that in the recovery thus far, private demand growth has been half that. This isn’t bad mind you, but with a fiscal drag of the size we’re talking that means, at best, growth will be negative. So prima facie Jim Rogers is right and recession is probably unavoidable. More to the point, and given recent trends in private demand, it could be nasty. The Congressional Budget Office for its part does actually forecast a recession on this basis and suggests that the unemployment rate would rise to as high as 9.1% - if the automatic cuts take place.
Now so far that’s all good and well. It’s sound and logical and I don’t have a problem with the analysis up to that point. The only thing I would mention is that the analysis is incomplete.
Just as important as the deficit reduction, in fact probably more so, is the way the deficit is going to be reduced. So, assuming no deal is made, the automatic reduction plan works as follows.
Chart 2 shows that the deficit, in dollar terms, is expected to fall from $1.1 trillion in 2012 to $641 billion in 2013 and $213 billion by 2022. That’s a total of $741 billion, with most of that falling to the 2013 calendar year. Using some figures provided by the European Central Bank, they reckon that in 2013, we are looking at a deficit reduction that will sum to $668 billion – or 4.1% of GDP.
The thing is, and as Table 1 shows, tax policies account for $532 billion of the $668 billion in deficit reduction - or about 80%. Is this important? You bet it is. It is critical in fact.
Spending cuts in 2013 only amount to $136 billion, which isn’t a great deal when you are talking annual expenditures of around $3.5 trillion and is easily offset by increased expenditure in other areas. Indeed spending over the 2013-14 fiscal years actually lifts modestly (falls an insignificant $9 billion in 2013 and then lifts $41 billion the following year).
That is, under the fiscal cliff scenario - or the worst-case scenario - government spending isn’t actually being cut at all. Think about that. If spending isn’t being cut, then it can’t be argued that the government’s deficit reduction will reduce growth.
As the table shows, the deficit reduction is actually being made through an increase in revenues - through a combination of tax cuts and through the improvement in economic growth. So the main thing we’ve got to worry about is the expiry of those tax cuts. So let’s look at that.
The Bush tax cuts were a series of broad-based cuts enacted over the 2001-06 period, with the bulk of that in 2001 (more toward households) and again in 2003 (more toward business). The Brookings Institution in conjunction with the Urban Institute estimates that if these were permanent tax cuts then the benefit to each income bracket would be as follows in Table 2.
As you can see, almost 75% of households received some benefit, with the average tax rate reduction in the order of 2.5%pts and a reduction in tax owed of almost $1900. Most of that is directed at higher income households, however, with the top quintile receiving a tax rate reduction of 3%, which equates to $6800 - on average. For the majority, or 80% of households, the reduction is a more modest $626.
Now this is important because the flipside is that if the tax cuts expire under the automatic deficit reduction plan, then 80% of households will see their tax rate increase by about 1.5%pts or $626 on average.
This is where perspective is extremely important, so consider this. In terms of rates paid, if you earn up to $34,000 you’re paying about 14% tax. Up to $84,000, you’re paying 20% tax. Indeed the top marginal rate, which kicks in for those earning over 380,000, is 35%. These are very low tax rates by any measure and the fact is, lifting a tax rate by one or two percentage points, on an already low rate, is unlikely to lead to a significant change in economic behaviour. Consumer behaviour isn’t that sensitive.
Certainly lower income families will hurt, they always do, and they may reduce spending as a result of a $200 or $300 increase in their tax liability. But then again, these families only account for a very small proportion of US consumer spending. The vast majority of spending comes from higher income households and here behaviour certainly will not change - on average.
There are two very good reasons for this. Firstly, and on average, people save money. Then secondly, people who aren’t saving money are generally paying down debt. And this is where the tax expiry will hit. Savings, and debt repayment schedules, not spending. Consider the following chart.
The household savings rate is running at about 4%. People can argue about whether that should be higher or lower, and it is depending on your income and wealth. Lower income households likely save nothing. Higher income households save 6% or 10%, or more, of their income. It varies significantly and the above chart is illustrative only. I’m using it to make a point though - the buffer is there. So I suspect this would be reduced more than spending , especially as the tax cuts undoubtedly favoured higher income earners to begin with. Worst case, spending might be cut a bit, but certainly not by an amount sufficient to cause a recession.
Similarly, record low interest rates have meant that debt servicing costs for US citizens are historically quite low, despite high debt. The lowest in decades. For the vast majority of homeowners this has allowed is a more aggressive principal repayment schedule. If the tax cuts expire, this will provide only a modest offset to these record low rates, without impacting the extremely attractive debt servicing environment more generally. As a rough guide, your average mortgage outstanding is about $170,000. On that you’re paying a 30-year rate of 3.5%, or there abouts – $6000 per year. The expiry of the ‘Bush tax cuts’ is equivalent to that 3.5% mortgage rate rising to a bit over 4% for a middle income American. Nothing in other words.
The bottom line then is that even if the US goes over the fiscal cliff, the impact on the economy is likely to be relatively small. In summary, there are three reasons for this.
- Government spending is not actually being cut.
- The deficit is being reduced through increased revenue and specifically, the expiry of tax cuts.
- The tax cut expiry in turn will largely be absorbed though lower savings rates and a slightly less aggressive debt repayment schedule. It is unlikely that consumers will cut spending.
Of course, the issue is whether they go over the cliff at all and I suspect the answer is no. Both houses of Congress are keen to extend the tax cuts and the debate is more about whether that should include high income earners or not.
But if the worst happens and no agreement is reached, I suspect the ensuing market panic will provide some excellent investing opportunities.