There is a lot of talk and press coverage about what is now commonly described as "the fiscal cliff." A more accurate description of what lies ahead is "looming policy warfare." We are facing policy confrontations of both a difficulty and magnitude that could derail our economy and the stock market.
The "fiscal cliff" is shorthand for several scheduled federal tax and budget changes that will occur at the end of 2012 in the absence of action by Congress acceptable to the President. This article examines the politics surrounding two of the most important of these looming changes: (1) President Obama's determination to raise income tax rates for families making more than $250,000 in adjusted gross income when the Bush tax cuts expire at this year's end, and (2) extension of the expiring payroll tax holiday. Focusing on these specific policy conflicts instead of the fiscal cliff more generally (i.e., potential loss of GDP in case of stalemate) provides investors a clearer sense of the challenges that lie ahead.
Income Tax Increase for Wealthy Appears Headed for Stalemate
President Obama and a number of his key supporters have indicated that, if re-elected, he will refuse to sign a bill extending the Bush tax cuts, which expire at year's end, unless it increases taxation for those making more than $250,000. Raising these taxes is at the core of Obama's re-election campaign message and a matter of principle on which he has been adamantly opposed to compromise. If re-elected, he will likely take an even more aggressive approach on this initiative, according to senior White House aides speaking off the record. Democratic leaders have suggested that he is willing to go so far as to allow all of the Bush tax cuts to expire in order to pressure the Republicans to agree to this increase.
On the other side of aisle, virtually every Republican member of Congress - and their standard bearer Mitt Romney - has signed Grover Norquist's pledge not to raise taxes, regardless of the consequences. Norquist has called opposition to tax increases the Republican Party "brand," to be defended like any valuable corporate brand. For many Republican members of Congress that pledge is now fundamental to their philosophy of governance, and raising tax rates would represent a radical departure from their platform of the past quarter century. They will vigorously oppose any tax increase for incomes above $250,000 or even $1,000,000. Tea party activists have targeted and defeated Republicans who demonstrated any willingness to seek a middle ground. While Republican leaders such as John Boehner may be inclined to raise taxes on the wealthy as part of some grand compromise, they are likely to be checked by tea party activists. The Republicans have in effect drawn a line on the issue of raising tax rates.
In 2010, the President and Congress kicked the can on this thorny issue down the road into this year's Presidential election and its aftermath. At this point, it appears likely that President Obama will be re-elected and the Republicans will retain control of the House of Representatives, with the Senate outcome too close to call. Currently, the Republicans have a 25 seat margin in the House. The highly respected Cook Political Report summed up the likely outcome for this year's House elections in late June:
"211 House seats are rated as solid or likely Republican, compared with 171 as solid or likely Democratic. If the 24 toss-up races split evenly between the parties, Democrats would score a net gain of just a single seat. Even if Democrats held everything in their solid, likely, and leaning columns, and also won every toss-up, they would still need to take two-thirds (12 of 18) of the districts rated leaning Republican to win a majority. That's a pretty unlikely scenario, absent a strong wind at their backs."The likely upshot is a President and House at loggerheads on raising tax rates.This is a case of political and policy civil war.
Payroll Tax Holiday Extension Will Face Stiff Opposition
The payroll tax holiday is also set to expire at year's end. The political dynamics surrounding its extension have changed in ways that have received little public attention.
Congress first enacted the payroll tax holiday in December 2010. President Obama requested and obtained this tax cut as part of his plan to stimulate economic growth. In exchange, he agreed to a two year extension of all the Bush tax cuts, including the cuts for wealthy taxpayers he had previously opposed. The American Association of Retired Persons (AARP), the nation's largest and most powerful special interest lobbying group, supported the extension of the tax holiday on the ground that it was a temporary measure.
Last September, President Obama asked Congress to extend the payroll tax holiday an additional year. In his speech before Congress he warned
"If we allow that [payroll] tax cut to expire -- if we refuse to act -- middle-class families will get hit with a tax increase at the worst possible time. We cannot let that happen. I know some of you have sworn oaths to never raise any taxes on anyone for as long as you live. Now is not the time to carve out an exception and raise middle-class taxes, which is why you should pass this bill right away."
After a bitter and protracted high profile fight, which roiled public opinion and the stock market, the Republican leadership backed off its opposition and passed the extension.
President Obama has refused to indicate whether he will seek a further extension of the payroll tax holiday later this year. Presidential Press Secretary James Carney set out the White House position at a press conference in early July:
Q: So you're not willing to say now, let the payroll tax cut expire in December?
MR. CARNEY: I'm not. The payroll tax cut is a temporary measure, and it was extended at the end of last year and early this year because the economic circumstances demanded it. And it's obviously a very controversial issue, as we saw, because of the great reluctance displayed by Republicans for week after week after week to extend the payroll tax cut. And the President's point today is, let's acknowledge that the contentious issues are going to be hard to resolve now.
Governor Romney has also refused to take a position on the payroll tax extension for 2013.
The failure of the Presidential candidates to take a position has deflected public attention from this key issue.
President Obama may seek a further extension at year's end in order to avoid increasing taxes on wage earners at a time when economic growth remains anemic. This extension would be especially helpful for much of his constituency; approximately 40% of wage earners (those with low incomes) pay only payroll taxes and no income tax. Congressmen from low income districts may actively lobby for further extension. It is virtually certain that President Obama will never agree to this "tax increase" on "middle class families" unless tax rates on the wealthy also increase.
Obtaining a further extension of the payroll tax cut will be even more difficult than last time because of two changes in the political/policy dynamics. First, the AARP, which supported the original holiday and stood silent during last year's rancorous debate on a further extension, announced its opposition to a further extension last April. In a letter to every member of Congress, which received scant press coverage, the AARP said:
"To avoid undermining Social Security's long term funding stream, AARP held that the payroll tax holiday would have to be temporary. In order to meet this condition, Congress should not extend the payroll tax holiday beyond the current year. Further extension of the payroll tax holiday would undermine confidence in the program and put at risk Social Security's dedicated funding stream and the hard-earned benefits of millions of Americans and their families."
Second, fiscal hawks share the AARP's concern that passing the payroll tax holiday for a third year would embed the cut in such a way that it would likely become permanent. Over just the past year the holiday has cost the government $120 billion in lost revenue. Spread out over a decade and inflation adjusted, it would add over $1.5 trillion to our federal debt, more than three times the amount that would be raised by increasing marginal tax rates on the wealthy during that period. This level of revenue reduction is unacceptable to those who are concerned with our burgeoning national debt, liberal and conservative alike. In short, there is a significant likelihood that following the election we will revisit the political consternation over payroll taxes that we experienced last year.
Investors Should Prepare for Market Volatility
We are headed into a political and policy maelstrom on these expiring tax cuts, as well as on other components of the "fiscal cliff". The coming battle over these issues is likely to be more contentious and difficult to resolve than last year's battle over the payroll tax extension. This dispute is highly likely to roil public opinion and the stock market. Investors in stocks should be reluctant to add to their positions at this stage and should be prepared to hedge or bail out if or when the crisis accelerates. Some long-term investors may choose to ride out the crisis if they can tolerate the volatility and have the patience to await reversion to the mean.