Articles - Fiscal cliff deal success but uncertainty remains

US reaches fiscal cliff deal, but uncertainty remains - Keith Wade, Chief Economist & Strategist, Schroders

 Risk assets have rallied after the fiscal cliff was averted, but fiscal uncertainty lingers over entitlement reform.
 The US Congress has passed a bill which will allow the economy to avoid the worst of the fiscal cliff. In a compromise deal the Bush tax cuts are extended to those earning less than $400k per annum, thus preventing the worst of the potential tax increases which would have hit households from this month. Spending cuts have also been delayed for two months.

 Markets have breathed a sigh of relief with risk assets rallying, suggesting that investors had not been that confident that the politicians would ultimately do the right thing.

 Higher taxes on the wealthy will not make a significant dent in consumption as they are likely to be largely met through lower saving. Despite the protestations of many Republicans, it is also difficult to see how an increase in the top rate of income tax from 35% to 39.6% will stifle American enterprise. However, the decision to allow the 2% payroll tax cut to expire will hit many families and is set to raise $95billion, about 0.6% GDP.

 When combined with other measures such as higher dividends, capital gains taxes and the temporarily delayed spending cuts, we are looking at a 2013 fiscal tightening of about $160 billion or 1% GDP. Whilst marginally less than we had factored into our forecast, the scope for upside risk to our 1.9% US GDP growth forecast for 2013 is limited.

 Despite the latest agreement, fiscal uncertainty remains with little progress being made on entitlement reform where Republicans and Democrats remain as divided as ever. Lifting the debt ceiling by end February/ early March and then going on to strike a longer term deal (a “Grand bargain”) promises to be a major challenge. Against this backdrop, the fiscal uncertainty which has weighed on longer-term investment decisions is set to persist. We believe this will weigh on growth as spending on durable goods and capital equipment is held back.

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