November 26th, 2012 | By Nick Sargen
In the aftermath of the elections financial markets immediately focused on the prospect of the two political parties being unable to reach agreement that would avert the so-called 2013 "fiscal cliff" of scheduled tax increases and spending cuts totaling 5% of GDP. More recently, markets have stabilized amid hopes that the fiscal cliff will be averted. What should not be lost in this debate, however, is that long-term deficit reduction is the central issue at stake, just as it was in the summer of 2011. The pending fiscal cliff is pivotal, because it is forcing politicians to act within a deadline just as the debt-ceiling deliberations did in August of 2011.
Keeping this in mind, investors need to weigh how much progress there has been toward deficit reduction since the elections. In my view, the most obvious change is that the Republican leadership is now willing to put revenue increases on the bargaining table. This is important, because the federal government's tax take is well below the post-war average of 18% of GDP. House Speaker Boehner and other Republican leaders have made it clear they prefer a reform of the tax code that would broaden the tax base to hikes in marginal tax rates.
For his part, President Obama has insisted that the top 2% of household incomes should pay higher tax rates, while the Bush tax cuts would be extended for all others. If this were to become law next year, it would boost federal revenues by about $45-$50 billion annually. All told, President Obama's latest budget proposal calls for a net tax increase of $1.6 trillion over the next 10 years, which is up from his previous proposal calling for $1.2 trillion in revenue increases.
While the focus has been on the revenue side of the equation, there has been less reporting about the spending side. One should keep in mind that since the financial crisis hit in 2008, federal spending has been running at about 24%-25% of GDP, well above the historic average of 20%-21% of GDP. Moreover, federal spending is projected to rise significantly in the future due to the aging of the population and growth of Medicare and Medicaid programs, which is why entitlement reform is necessary to make these programs actuarially sound.
On this front, President Obama's latest budget includes little in the way of net new spending cuts, as he proposes roughly the same amount of spending increases as cuts. Just over 50% of the President's proposed deficit reduction over the next 10 years comes from the caps in discretionary spending that were passed into law in 2011 and the savings from winding down the wars in Iraq and Afghanistan. (Note: since the caps are already law and the war costs won't be incurred, both are factored into the current policy baseline.) All told, the President's budget proposals call for just under $2 trillion in deficit reduction over 10 years, or roughly half the total that the President and House Speaker Boehner sought 18 months ago.
My bottom line is that investors' fears about the fiscal cliff are likely to give way at some point to the realization that a compromise will be reached that falls well shy of the $4 trillion deficit reduction target called for by the Simpson-Bowles plan. This figure is widely regarded by experts as necessary to put the U.S. budgetary outlook on a sustainable path. It is also the tally that the rating agencies have indicated they will use in assessing the creditworthiness of U.S. government debt. Accordingly, failure to reach such an outcome would probably result in a downgrade of U.S Treasuries.
This outcome would likely spawn a sell-off in U.S. financial markets, although one that is less severe than if no agreement were reached. The damage to the economy in this case is likely to be limited in the short-run, as fiscal drag of 1.5%-2% of GDP is manageable.
Failure to reach a more substantive agreement, however, could have longer-term consequences for the economy, especially if businesses lack confidence in policymakers. U.S. companies already have cut back significantly on capital spending as they await the outcome of the budget deliberations. If they conclude that the two political parties are postponing making hard decisions or that the Obama Administration is pursuing tax and spend policies, business capital spending and hiring could stay anemic for much longer. If so, financial markets would eventually weigh in as well.
In sum, while investors fear that the two political parties will not be able to reach a deal to avert the fiscal cliff, I believe the greater risk is that they will reach a compromise that falls short of delivering much needed reform of the tax code and entitlement system. If so, investors may be relieved that the risk of an imminent recession has lessened. However, the opportunity to put the country's finances on a stable trajectory will have been missed.