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Forward Markets: Macro Strategy Review for December 2012

December 3rd, 2012
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by Jim Welsh, Macro Strategy Team, Forward Markets

The Fiscal Cliff, Fiscal Cliff 2, Fiscal Cliff...

Over the last 30 years, members of the media have routinely forgotten the old adage, “The President proposes and Congress disposes.” This has led to the widespread misunderstanding that the deficits of the 1980s were attributed to President Reagan (even though his annual budgets were considered “dead on arrival” once they reached Capitol Hill), and that President Clinton was responsible for the $1.9 billion and $86.4 billion surplus in 1999 and 2000, respectively. Presidents can and do exert influence, but they have no constitutional authority regarding the budget. The U.S. Constitution lays the responsibility for passing a budget entirely on Congress. The executive branch has zero responsibility. In 1998 the Supreme Court ruled in Clinton v. City of New York that the Line Item Veto Act of 1996 was unconstitutional, holding that the line-item veto violated the Presentment Clause of the Constitution. The Presentment Clause (Article I, Section 7, Clauses 2 and 3) states: “All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills”. Perpetuating the myth that the executive branch of government is somehow responsible for the budget does provide Congress political cover.

Follow up:

After many months of campaigning and almost $6 billion spent by both parties on the 2012 election, we can all breathe a sigh of relief that it’s over. Of the 535 members of Congress during the last two to four years, close to 510 members will be returning to Washington, D.C. in January 2013. Unfortunately, these members are, for the most part, the same members of Congress who placed party ideology over the welfare of our country by failing to pass a budget in the last three years. Passing an annual budget that provides for the fiscal soundness of this country’s future is important and clearly a primary responsibility of each member of Congress. While they were fiddling, our country ran federal budget deficits of $1.3 trillion in 2010 (9% of GDP), $1.3 trillion in 2011 (8.7% of GDP), and $1.1 trillion in 2012 (7% of GDP). Maybe members of Congress were just too busy campaigning for re-election, or possibly, they simply do not understand or appreciate how the “fiscal cliff”, and more importantly, the “fiscal grand canyon” threaten our nation’s future.

Since the beginning of 2010 (or the past 11 quarters), our economy has grown 2.1%. The fiscal cliff could be as large as 4% of GDP if all the tax increases and spending reductions are allowed to take effect in January. The image of a cliff and basic math (GDP + 2.1% - 4% = -1.9% GDP) suggest the economy will plunge into recession by the end of January if Congress fails to intercede. This is not likely to happen, even if Congress continues to fiddle. It is the progressivity of fiscal tightening that will drag the economy down in the first half of next year. For instance, the 2% reduction in the Social Security tax is likely to be rescinded. Median income is about $50,000, which means the average wage earner in the U.S. is going to pay $1,000 more in Social Security taxes in 2013. After receiving $20 less in their first paycheck of 2013, will the average worker slam on the spending brakes? The Bush tax cuts are also likely to go away on those earning more than $250,000, so they will pay $11,000 or more in taxes next year. Will the most affluent stop going to the mall? Most consumers are more likely to tap into savings or use a credit card for awhile before altering their current spending habits. However, slower growth in government spending and the cumulative impact of higher taxes would likely tip the economy into recession by mid-2013.


We may be incorrigible optimists since we would like to think those in Washington understand the gravity of the fiscal cliff and will address it. It’s certainly possible that after trying to negotiate a deal, the talks will reach an impasse. After the recent election, both parties proclaimed to the American people their willingness to do what’s best for the country. But when the brief honeymoon is over, they will have to work out the details. And the devil is in the details. Despite reservations, our expectation has been that Congress will minimize the 4% hit to GDP. They will accomplish this by allowing the tax increases on those earning more than $250,000 to take effect and rescinding the 2% reduction in Social Security taxes. On the spending side, they will likely allow most, if not all, of the unemployment insurance program to expire, and allow the defense department to decide which military programs will be cut. This would minimize the immediate negative impact on the economy to 1.5 - 2.0% of GDP, while buying Congress time to address the remaining portion of the fiscal cliff. The deficit hawks will not be happy, and some will understandably call this “kicking the can down the road.” But Congress must address the fiscal cliff in a balanced way so economic growth is not unduly impaired. Going the way of Europe, and pursuing austerity for austerity’s sake, has not worked for Greece or Spain, both of which are mired in recession with little deficit improvement to show for their suffering.

We acknowledge Congress’s proclivity to duck their budgetary responsibilities, as they have the last three years. But 2013 may prove different given the widespread media attention the fiscal cliff has received. As part of a short-term solution to avoid the full brunt of the fiscal cliff before December 31 (or shortly thereafter), we believe Congress may authorize a “Super Duper Committee” — in response to the failure of the Senate Finance supercommittee — to achieve an additional $3 – 4 trillion in deficit reduction over the next 10 years. This would be accomplished through revenue increases and spending reductions by July 4, 2013. And to further prove their budgetary discipline, Congress may set another sequestration deadline (October 1, 2013) that could mandate additional tax increases and spending reductions, if the Super Duper Committee is unable to come to an agreement. If some of this seems like déjà vu all over again, it shows you’ve been paying attention to how a dysfunctional Congress behaves.

Even if Congress is able to accomplish all of the above, the reality is the budget deficit will not narrow as much as projected. When the Congressional Budget Office (CBO) tabulates the amount of revenue it expects the government to collect from a tax increase, it uses static accounting, which assumes taxpayer behavior won’t change. This assumption challenges human nature, since most humans are wired to respond to negative and positive incentives. Historically, if the CBO projects $100 billion in additional tax revenue due to a tax increase, the government usually comes up short as taxpayers respond to the tax increase by making choices that reduce the impact of higher tax rates on their finances.

Conversely, tax cuts have usually resulted in more tax revenue than projected by static accounting, as taxpayers elect to receive more income since the government’s take is less. This behavioural dynamic is especially true of capital gains, since investors have far more flexibility in when and how much capital gains they claim in any tax year as compared to income from wages and salaries. Even if Congress does address the fiscal cliff, the odds are the deficit will not decline as much as projected, since tax revenue will not rise as much as expected. We will also venture a guess that spending reductions will not curb the increase in government spending as much as expected. OK, call us optimistic cynics.


There is also the unintended consequence of relying too much on capital gains to close the budget deficit. In addition to investors exercising more control over the amount of capital gains they will take in any given year and when they will take them, there is also the small matter of fluctuations in the stock market. During a bull market, the government will reap more capital gains tax revenue, which politicians invariably and gladly incorporate into baseline spending. This means future spending is dependent on capital gains tax revenue remaining high. The Clinton budget surplus years of 1999 and 2000 owed much to the technology mania that boosted the stock market’s valuation in those years and the resulting capital gains tax revenue boom. When the stock market declined in 2001 and 2002 as the dot-com bubble deflated, capital gains tax revenue collapsed, contributing to the budget deficit in subsequent years. If Congress wants to boost tax revenue through higher capital gains taxes, they should be required to use a five or 10-year average of capital gains tax revenue to avoid overspending during bull markets, and needing even higher tax rates during bear markets to lower future budget deficits.

From the Hula Hoop craze to environmental laws, which resulted in cleaner air and water throughout our country, California has long been considered a trendsetter for the rest of America. American actress Mae West once said, “Too much of a good thing can be wonderful.” But that isn’t always true for taxes, government spending and regulation. California’s unemployment rate is 10.2%, well above the national average of 7.9%. Inflation-adjusted per-capita government spending in California rose 42% between 2000 and 2010. And according to the U.S. Census Bureau, at 23.5%, California has the highest poverty rate in the country, despite the substantial increase in government spending. The U.S. Bureau of Economic Analysis estimates per-capita personal income fell almost 1% between 2008 and 2011. The Mercatus Center at George Mason University, a nonprofit, American market-oriented think tank, ranks California as the fourth worse state in terms of business regulations. The Tax Foundation, a nonpartisan tax research group, ranks California as the fourth most heavily taxed state. The California Taxpayer Association has reported that California has the second highest personal tax rate and the highest sales tax rate in the nation. And that was before the top personal tax rate was increased to 13.3% and the sales tax was bumped up 0.25%. The Census Bureau estimates that between 2007 and 2010, almost 500,000 people left California for better pastures, and it’s likely the exodus out of California continued in 2011 and 2012. California projects the recent tax increases will garner an additional $6 billion in revenue. That’s likely to prove optimistic, as the negative incentives of higher personal taxes, sales taxes and business regulations result in a shrinking tax base and less tax revenue. Unintended or not, public policy choices have consequences, whether it is at the state or national level of government.

The Congressional Budget Office will “score” the details of any budget agreement reached by Congress, and make an estimate of how much the deficit will decline in coming years. The most important budget-busting bogey is the expected GDP growth rate the CBO will use to estimate future tax revenue and spending. The higher the assumed GDP growth rate used by the CBO, the more tax revenue it will project the government will receive and thus a smaller budget deficit. There is a high probability the CBO will assume a higher GDP growth rate than is likely to occur, especially in the next few years. Given the structural challenges facing our economy, Europe and China, it would be fortunate if GDP growth in the U.S. averages more than 2% in the next few years. Too pessimistic? Consider how much support our economy has received from fiscal and monetary policies during the last three years. We’ve run deficits greater than $1 trillion each year, which amounts to an average of 8.2% of GDP. The Federal Reserve has held interest rates near zero percent, and launched the second and third rounds of quantitative easing (QE2, QE3) and Operation Twist to keep mortgage rates low and boost stock prices. Despite the extraordinary fiscal and monetary stimulus, GDP growth has been just 2.1% since the end of 2009, about half the post-World War II recovery average. Our guess is the CBO will project GDP growth in coming years of at least 3% in their budget assumptions. Its estimates of tax revenue will be much higher than are likely to be realized if GDP growth is just 2% or less, as we expect. This means the budget deficit will not narrow as much as the CBO will estimate over the next decade, so the budget deficit problem will remain an ongoing challenge.

Let’s hope that all the attention on the fiscal cliff will result in Americans learning more about the budget challenges facing our country over the next few decades. Our concern is that any deal which addresses the near-term budget shortfall will engender complacency and the assumption that all is well with the budget. Nothing could be further from reality. All the recent hand-wringing and headlines refer only to the $600 billion in tax hikes and spending cuts. According to the Congressional Budget Office, the United States has unfunded liabilities related to Medicare, Social Security, Federal debt, military and federal employee benefits, and obligations of state and local governments of $65 trillion over coming decades. We have referred to these unfunded liabilities as the “fiscal grand canyon.” The fiscal cliff is $600 billion, but the fiscal grand canyon is 100 times larger. The fiscal challenge confronting us is far more a long-term issue than a short-term problem requiring a quick fix in 2013. The problem of unfunded liabilities has been growing for decades, so it is not a new problem. Nor is the lack of Congressional leadership in passing an annual budget that provides for the fiscal soundness of this country’s future. If Congress focuses simply on the fiscal cliff next year, without adequately addressing the fiscal grand canyon, we will have to endure fiscal cliff 2, fiscal cliff 3 and so on.

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