Fiscal cliff FAQ

Fiscal cliff. The words Fed Chairman Ben Bernanke used to describe the tax increases and spending cuts that will automatically take effect in the United States at the end of the year. These two words have also been heavily overused by the media and we hope will be completely forgotten in 2013.

You’re correct if you think I’m tired of talking about the fiscal cliff. But it’s certainly worthwhile to answer some commonly asked questions to help clients put the media blitz in perspective.

Read: Cliff hanger: talks stall in Washington

What is the fiscal cliff?

It’s a term used to describe automatic tax increases and expense reductions that will happen at the end of the year. “Fiscal” refers to the fact that we are dealing with government and not central bank policy, while “cliff” attempts to illustrate what the U.S. economy might approach if these tax increases and expense reductions are allowed to occur at the same time.

The idea is that if average Americans see their disposable income declining and the government removing investment from the economy, consumption and economic growth will suffer. I do not dispute this conclusion.

At the end of the year:

• Income tax cuts implemented by President George W. Bush early last decade will expire without a legislated extension. If they’re not extended, taxes will increase to rates seen during the Clinton presidency.
• A payroll tax reduction that went into effect in January 2011 will expire.
• The Affordable Care Act will see Medicare payroll taxes increase and the imposition of a new investment income surtax of 3.8% on dividends and capital gains for high-income taxpayers.
• $1.2 trillion of budget “sequestration” will be implemented over a 10-year period. This is just a fancy way of saying budget cuts. When Congress raised the debt ceiling last year, Republicans and Democrats agreed to form a Super Committee to find $1.2 trillion of budget cuts in addition to the $900 million already agreed to. If the Super Committee couldn’t agree on those cuts or if a plan was not passed by Congress, then cuts would begin automatically on January 1st, 2013. In other words, Congress “kicked the can down the road” to solve the problem at a later date, but the can will be kicked back to Congress at the end of 2012.
• An unemployment insurance benefits extension for 2012 will expire.
• Various other tax provisions will expire and spending cuts will occur.

This list isn’t exhaustive, but it does hit the major issues. A reduction in disposable income for consumers and a reduction of investment by the government will hurt what has been a painfully slow economic recovery in the United States.

Read: Cliff deal unlikely before Christmas

The press hasn’t stopped talking about the fiscal cliff since President Obama won reelection. Should investors panic if we don’t see a deal from Congress by the end of the year?

The fiscal cliff is an important issue because it focuses attention on America’s increasing deficit, involves trillions of dollars, and the consequences would have a very negative impact on U.S. economic growth. But because the impact could be severe, it’s hard to believe politicians could be foolish enough to let it happen.

Admittedly, U.S. politicians have taken questionable action in the past. But even when they do the wrong thing, they usually make it right once they see the consequences. So a deal could be reached before January 1, but it could also be reached after January 1. Regardless, they will make a deal simply because failing to do so would be unacceptable and both Democrats and Republicans are fully aware of this.

Furthermore, if the U.S. “went over the cliff,” the impact of the tax increases and spending cuts would not necessarily hurt the economy immediately, so politicians know they have more time to work with even if the time remaining continues to disappear. Investors shouldn’t panic.

Read: The U.S. could survive a fiscal cliff fall

Will the markets fall if we don’t have a deal by the end of the year?

There will be short-term pressure on equity markets during the last week of December and beyond until a proper deal is negotiated. However, this does not change our longer term outlook for global markets, nor does it signal that markets are extremely expensive. In fact, any short-term downward pressure on equities could provide a window of attractive buying opportunities.

Should I sell stocks in my portfolio just in case the markets fall?

No, because any impact of the fiscal cliff on the markets will be short term and they will recover when a deal is finally reached. Investors should continue to hold defensive, dividend-yielding equities if selling pressure and volatility increase.

Why haven’t the Democrats and Republicans found a resolution already?

The fiscal cliff is more of a political issue than an economic or financial issue. The parties need to find a resolution where both Democrats and Republicans will look good and avoid blame from the voting public. That’s why so many of these divisive issues are solved at the last minute in Washington – it’s not the end result that always matters, it’s how you play the game.

If you are not as concerned about the fiscal cliff, is there anything investors should be watching that is a greater concern going into 2013?

Yes, the debt ceiling negotiations in the new year. The U.S. Treasury is limited in how much money it can borrow. The only way it can borrow beyond its limit is if Congress agrees to raise the debt ceiling. The fiscal cliff and the debt ceiling issues are obviously related, but President Obama has refused to negotiate a fiscal cliff resolution that is dependent on what will be done with the debt ceiling.

Read: U.S. debt fight may spook markets

The U.S. government is forecast to run out of money in the first quarter of 2013 unless the ceiling is raised, so once we get past the fiscal cliff debacle, a new debt ceiling debate will commence. We are more concerned about the debt ceiling because an inability to raise it would result in a shutdown of the U.S. government, which would likely have a more immediate impact on the U.S. economy.

Gareth Watson is the Vice President, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @Gareth_RGMP