A terminology / situation currently gripping the market is "fiscal cliff". Suddenly Euro zone's debt crisis and China's slowing growth are on back burner for the market watchers. What is both important and urgent is resolution to fiscal cliff by the US lawmakers.
What is fiscal cliff?
Fiscal cliff is a term that describes an economic situation which is a combination of tax increase and spending cuts scheduled to kick in on 1st January 2013, if existing laws are not changed before end of 2012. For all practical purposes, year ends in a week and a resolve is nowhere in sight. Hence all the sturm und drang!
What caused this?
Bush tax cuts expires by end 2012 and spending cut (under the Budget Control Act of 2011) takes effect from 2013; these are two main contributors to fiscal cliff. There are also other laws such as those governing temporary pay roll tax cuts and federal unemployment benefits amongst others expiring end of this year, worsening the situation.
Possible scenarios and effect?
Going ahead with original plan is scenario 1. With increase in tax revenues and spending cuts, this will considerably reduce deficit as a % of GDP. On the flip side this would bring down GDP significantly and push the economy into recession. An alternate fiscal scenario could be arrived at by changing some of the laws. While this would result in not so steep tax increases and spending cuts, it would result in higher deficit.
What is holding up a resolve?
Political divide. Republicans have proposed that Bush tax cuts be extended in its entirety. Democrats want more targeted approach where tax cuts would end for people in high income bracket and would continue for others. Neither of these has gotten through, creating a logjam. Negotiations are on, now with a tough timeline.
Can congress buy more time?
Yes, laws could be changed retrospectively, if a consensus is reached after the deadline. So fiscal cliff need not necessarily be an impediment to growth, if a mid path is agreed on even after 2013 has already begun. However cost of indecision will affect spending pattern of individuals and corporations in anticipation of changes taking effect. Longer it takes to resolve, higher will be the impact on GDP.
Hope market receives a timely christmas gift!!