Difficult Tax Scenarios Add to US Recession Risk

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This piece was originally written for Encima Global.

With the market-favorable Fed announcement and German court ruling, we’re at the end of the August-September spate of market-favorable news. It included the ECB’s bond buying plan, ECB collateral relaxation to fund Greece during the August holiday, the Fed’s ramp-up of QE3 and Germany’s formal backing for Draghi and now for the ESM.

We think the market’s focus will shift to the ineffectiveness of Fed bond buying, the U.S. tax increase and economic weakness.
We expect a swing to bad news on the economic front in coming months -- weakening corporate earnings, U.S. tax uncertainty hitting job confidence and auto sales, confessions of higher fiscal deficits in the U.S. and Europe, and deeper recessions in Europe’s periphery. Spain’s unemployment rate is 25% and climbing, with youth unemployment in Spain and Greece much higher. Greece would be out of cash within days if not for the ECB’s August-September willingness to keep supplying Greece with actual euros in return for Greek treasury bills – Greece’s tax receipts are weak and government spending per GDP is still higher than in any year prior to 2009. China may loosen monetary policy, which would be good news, but would probably be too late to boost China’s growth until well into 2013.
We think at least a temporary year-end tax rate increase is likely given the legislative situation and the polarization of the presidential campaign. Whether President Obama wins or not, it is hard to see a tax deal with the House in December, though it is conceivable that there could be a December deal to alter the sequester which primarily cuts defense and Medicare. On taxes the president has rejected blanket extensions (like the one in December 2010) and advocated targeted tax increases while many Republicans including House leaders will be constrained by their opposition to new taxes from a growth standpoint and, for many, their tax pledge to “oppose any and all efforts to increase the marginal income tax rates for individuals and/or businesses; and oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates.”

Thus, the likelihood is that taxes will rise at least temporarily on January 1 including:

income tax rates for all brackets, probably applied through withholding taxes starting in January;
the alternative minimum tax (big increase for middle and upper income taxpayers);
the employee portion of the payroll tax rate (which rises from 4.2% to 6.2% on the first $113,700 of income);
the estate tax and gift tax;
the tax on interest income (by the underlying increase in the income tax rate plus 3.8 percentage points through the extension of Medicare taxes to passive income);
long-term capital gains rate (to 23.8% from 15%);
and the dividend rate (to the ordinary income rate of up to 43.4% from the current 15% rate.)
In addition, there are numerous expiring provisions (special tax credits) scheduled to expire at year-end, all of which have strong constituencies. Absent the “doc fix”, Medicare payments to doctors decline sharply starting January 1 adding to the political pressure on Congress to act.
The top marginal income tax rate (which has the most growth impact and hits a high percentage of the income earned in small businesses) will rise to 39.6% plus the
increase in the Medicare tax rate to 3.8% (current limit is 35% plus 2.9% for Medicare). The total is a 43.4% top marginal rate, a 14.5% tax increase from the current 37.9% combined rate.
New York State charges 6.9% (8.8% for incomes over $2 million) and New York City charges another 3.9%. Both are deductible from federal income tax, but the Pease
limitation is scheduled to resume in 2013 after a three year holiday, reducing deductions for charities, state and local taxes and mortgage payments by the lesser of
20% or 3% of adjusted AGI. That will push the combined marginal rate for NYC toward 50%, not counting the mass transit payroll tax and the unincorporated business tax.
The 12.4% combined employer/employee contribution to social security adds as much as $14,000 in taxes to the above but is not part of the top marginal rate because the tax doesn’t apply to incomes above $110,100 in 2012 ($113,700 in 2013.)

After that, we think these are the most likely tax scenarios in 2013:

If Obama wins, the House (likely still Republican) might go through the motions of offering a Republican-oriented tax cut to the Senate once it organizes in February. Tax bills have to originate in the House. CBO and the Joint Tax Committee would score it as a massive increase in the deficit ($400 billion in the remainder of FY2013 and more in subsequent years). This triggers strong budget points of order in the Senate, making a deal hard to pass quickly even if Senate Democrats hold the Senate and have the president’s support. It’s unlikely the House would enable the reconciliation process. The result is an impasse extending at least into March causing chaos given the magnitude of the taxes involved. It’s not clear whether a compromise – say to reverse all of the tax increases except a higher rate for incomes above $1 million or an equivalent hit on upper income taxpayers through limitations on deductions -- could win a majority in the House and the necessary 60 votes in the Senate.

Separately, the debt limit will be exhausted early in 2013. Moody’s has said it is watching the process and will downgrade the U.S. credit rating unless there’s a plan to lower the debt-to-GDP ratio. (We’ve proposed replacing the debt limit law, which is designed to facilitate more debt, with a debt-to-GDP limit that restrains spending.) As the debt limit crisis approaches, the White House might shut down non-critical government functions for a few days in an effort to force the House to go along with an increase. It’s unclear how much leverage a shutdown and the risk of a technical default will give the president. Moody’s will probably carry out its first downgrade, but we don’t think S&P will do a second downgrade. At some point, we are confident either presidential candidate will be able to avoid a default and push through an increase, but there will be substantial costs.
We think the likelihood is tax and debt chaos at least through March, discouraging investment and risking recession. President Obama’s prospects rose and then fell in 2012 on jobs data. Per Intrade pricing, they have risen back to 61% on swing state polling data and the convention. The probability of Republicans controlling the Senate is now just above 50%. The probability of Republicans controlling the House is running at 80%.

If Romney wins and Republicans take control of the Senate, it’s possible to use an FY13 reconciliation process (enabled by a quickly-organized joint House-Senate budget resolution) to reverse the tax increase and increase the debt limit. In the second quarter, there could be an FY14 budget and reconciliation process leading to more comprehensive tax reform legislation.

However, there are several procedural challenges. A) Reversing the January 1 tax increase would be scored as increasing the deficit. There would be tension among Republicans between the urgency of reversing the tax increase to get growth going and the desire for spending offsets to reduce the deficit. B) Under the current baseline, subsequent tax reform is difficult because it scores badly – there’s no acknowledgement of the growth impact of tax reform, and it’s expensive to make permanent the current tax rates and extend needed provisions like the AMT patch and the credit for research and experimentation. One approach would be for Congress to establish a baseline that includes the continuation of current tax rates and provisions in order to lower the scoring and encourage tax reform.

receipts and outlays

In the meantime, the fiscal situation Is worsening. The gap between receipts and outlays remains large. There is no plan to close it. In its baseline, CBO projects growth in social security, Medicaid, Medicare and interest payments. Due to arbitrary spending caps, it projects a sharp decline in defense and all other spending as a share of GDP, an outcome that is highly unlikely. If all other spending were to be maintained as a percentage of GDP (the dotted line in the graph), federal spending would be three percentage points of GDP higher in 2022 than in the baseline and the deficit/GDP ratio three percentage points higher plus the interest expense on the borrowed funds.

fed spending breakdown