Will Resolution of the Fiscal Cliff Squelch Consumption?

The U.S. averted the Fiscal Cliff with passage of the “American Taxpayer Relief Act of 2012” on December 31. Economists think resolution of the Fiscal Cliff will lead to a fiscal drag of 1% on GDP and adversely affect the mainstay of the economy: the American Consumer.

We’re not convinced this will happen and believe tax increases overstate the related negative consumption impacts. While we expect some weakness in consumption, it is likely to be transitory and confined in the first half of 2013, before recovering above-trend in the second half.

Key elements of the Fiscal Cliff resolution:

Before moving to the crux of my analysis, let’s review the central parts of the Fiscal Cliff resolution.

  • Permanent extension of the Bush tax cuts for taxable income less than $450k
  • Reinstates top 39.6% rate on taxable income above $400k for single filers and $450k for joint filers
  • Capital gains tax raised to 23.4%
  • One-year extension of emergency Unemployment Insurance benefits
  • Expiration of payroll tax holiday
  • Permanent AMT patch. Increase exemption amount and indexed to inflation
  • Permanently sets rate at 40% and $5 mil exemption per spouse indexed to inflation

Economic Impact from the Fiscal Cliff Resolution

Economists estimate a fiscal drag of 1% with the expiration of the payroll tax and the tax increases for upper income filers contributing 80% of the drag (see Table below).

Fiscal Cliff Effects on the Economy


$ bn

Drag as % of GDP

Upper-income tax hike



Expiration of payroll taxes



Extension of unemployment insurance



Budget control act spending cuts






Source: JP Morgan, Pioneer Investments

2013 Tax increases will not hit consumption as many fear

  1. Consumers do not appear to have spent the bulk from the payroll tax cut. The payroll tax holiday expired at the start of the year. This will bring back the payroll taxes (social security and Medicare) withheld from workers’ paychecks from 4.2% to 6.2%. This tax increase will affect approximately 155 million workers in the U.S. and will lead to a drag of 0.6% of GDP. We believe the negative consumption impact from the payroll tax rise should be less than the estimated $125bn hike in these taxes in 2013. This is because the temporary 2% payroll tax rate cut in 2011-12 didn’t stimulate consumption as intended. According to a NY Fed survey, only 36 cents of each $1 payroll tax cut in 2011 was consumed while 24 cents was saved and 40 cents was used to pay down debt (A Boost in the Paycheck: Survey Evidence on Workers’ Response to the 2011 Payroll Tax Cuts).
  2. Upper income will allow savings rate to fall. The Fiscal Cliff resolution will raise taxes for singles making $400k and couples earning $450k and restore tax rates to pre-Bush levels of 36% and 39%. This is expected to add $309bn to government revenues and lead to a drag of 0.2%. However, we surmise the income tax hike to upper income groups should see a drop in savings that limit the negative near-term consumer spending impact (see Chart). Savings rates are much higher in the Top 1% and 5% at 51.2% and 37.2%, respectively.blog - Savings Rate
  3. Extension of the Unemployment Insurance (UI). The American Taxpayer Relief Act extended the emergency unemployment insurance benefits for another year. Of all the fiscal stimulus measures, economists have argued, and we concur, that unemployment insurance is the most effective at stimulating the economy. According to the CBO, each dollar of UI benefits raises aggregate economic activity by $1.10. The reason there is a large positive effect is that families on UI rely on it to maintain non discretionary spending, thus the money is rapidly spent rather than saved.
  4. Wealth effects are well supportive. The consumer is feeling wealthier that should support consumption in 2013. There has been a dramatic turnaround in house prices with the Case-Shiller house price index rising from -3.6% yoy in October 2011 to 4.3% yoy in October 2012. While the change in house prices has been impressive, the rise in equity prices has been more impressive. The S&P 500 index has surged 14.2% from a year ago. The wealth effect is helping to bolster consumer confidence that is now at its highest level in 5 years with the University of Michigan consumer confidence sentiment at 76.5 (rolling 12m average). In the end, this will help private consumption and offset the tax increases. Barclays’ econometric analysis reveals there will be lagged effects from the rise in house and equity prices that will add approximately 1% to consumption during the second half of 2013 with house prices projecting to add 0.25% to consumption while equity prices will add 0.75% to consumption.
blog - Wealth Effect

Investment Implications

We expect risky assets to have a solid year in 2013 given our benign view of the U.S. economic outlook and, most importantly, no meaningful hit to private consumption. We remain negative on Treasuries as risk reward does not support lower yields. In fact, there is even a greater than 50% probability that interest rates begin to rise in earnest in H2 2013 as the U.S. economy gathers steam led by consumption.

© Pioneer Investments


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