Economic Research April 26, 2012 Special Report Contents: US: fiscal cliff notes I: Head-first into the fiscal meat grinder What about the debt ceiling? How big are the Bush tax cuts? II: The 2012 political season BCA—pain all around Payroll tax and unemployment benefits III: Looking beyond the cliff Fading of stimulus A farewell to arms And in summation... • Current law has a massive fiscal tightening—around a half trillion dollars—set for the beginning of next year • Our baseline view is that the vast bulk of this fiscal tightening will be deferred to later years • Even so, the uncertainty over the fiscal outlook is likely to loom over the economy until after the November election • Even with an extension of most of the expiring year-end measures, federal fiscal policy will weigh on growth • This fiscal drag, around a 1.4%-pt drag on GDP growth next year, is likely to occur regardless of the November election outcomes The political path between now and the November elections is relatively clear: only minor new legislation is expected to come out of Washington, Mitt Romney will challenge the Democratic incumbent Barack Obama for the White House, the Republicans will look to defend their hold on the House of Representatives and will attempt to wrest control of the Senate from the Democrats. The stakes of the election outcome—always enormous—will in this cycle also be immediate. At the end of the year, only seven weeks after the election, the nation will arrive at a fiscal cliff: the scheduled sunsetting of the Bush tax cuts, worth hundreds of billions of dollars per year, the expiration of the 2%-point payroll tax holiday and emergency unemployment compensation, and the automatic budget cuts written into the Budget Control Act as penance for the Supercommittee’s failure to reach agreement last fall. All told, under current law, through a combination of tax hikes and spending cuts, fiscal policy is set to tighten by over $500 billion at the beginning of next year. Not only is that an enormous sum—almost 4% of GDP— but it is all set to occur at a single point in time. Were current law to remain unchanged, this would lead to an almost certain recession. The implied fiscal drag, set against a recovery that has struggled to average 2.5% GDP growth, would probably be too much for the economy to shoulder. However, laws can be changed. And it is our best guess that these laws will be changed, and that most of the tightening of fiscal policy will be temporarily or indefinitely deferred to future years. If current polling holds up, The January fiscal cliff Michael Feroli Calendar year 2013 Sunsetting of Bush tax cuts Expiration of payroll tax holiday Expiration of emergency unemployment benefits Budget Control Act spending cuts Total $ bn $280 $125 $40 $98 $543 % of GDP 1.8% 0.8% 0.3% 0.6% 3.5% (1-212) 834-5523 michael.e.feroli@jpmorgan.com Deficit decomposition under J.P. Morgan policy assumptions FY, % of GDP Deficit Automatic stabilizers TARP Structural deficit Fiscal thrust or drag Memo: fiscal thrust assuming all of fiscal cliff is realized 2009 -10.2 -2.1 -1.1 -7.0 4.1 4.1 2010 -8.9 -2.3 0.8 -7.4 0.4 0.4 Note: fiscal thrust is the negative of the change in the structural deficit, adjusted to remove TARP. 2011 -8.6 -1.9 0.2 -7.0 -0.4 -0.4 2012f -7.7 -1.7 -0.1 -5.8 -1.2 -1.2 2013f -6.1 -1.7 0.0 -4.5 -1.4 -3.3 www.morganmarkets.com 2 2 3 5 6 6 7 7 8 8 JPMorgan Chase Bank NA, New York Michael Feroli (1-212) 834-5523 michael.e.feroli@jpmorgan.com divided government is likely to persist after the election. While each side sees elements of current fiscal policy that it would like to change, neither side has an incentive to throw the economy into recession. The game of chicken may prevail into late December, but we believe that—as was the case in late 2010 when faced with a similar situation—the path of least resistance will be to extend current policy for another year or two. Even with this relatively benign outcome, the uncertainty regarding numerous aspects of tax policy will likely affect decision-making, cause business and household choices to be delayed, and retard the pace of economic activity closer to year-end. There are risks. The first risk is that one party or another gambles on taking a hard line. A second, smaller risk is that one party gains control of both the White House and Congress. This will likely imply more near-term tightening of fiscal policy, as each party has oxen they would be happy to have gored. Even with a year-end agreement to extend expiring fiscal measures, fiscal policy will continue to weigh on growth next year for two reasons: Economic Research US: fiscal cliff notes April 26, 2012 What about the debt ceiling? One issue that is sometimes included in the host of year-end fiscal questions confronting the economy is the prospect of the Treasury again running into the debt ceiling. Recently the room under the debt ceiling has been about $780 billion. By our estimate of the deficit, this implies that the debt ceiling will be hit in December, around the same time all of the other fiscal issues come to a head. Recall, however, that Treasury can and has used various accounting gimmicks to extend the “drop dead” date on the debt ceiling. Last year, these gimmicks bought the Treasury about two-and-a-half months of extra time. Assuming a similar capacity to use these gimmicks, this would imply the “drop dead” date on the debt ceiling isn’t until February, after Inauguration Day 2013. If there is a “grand bargain” in the lame duck period between Election Day and Inauguration Day, it will likely include an extension of the debt ceiling. However, such an extension does not have to happen until well past the other fiscal cliff issues. Debt ceiling headroom: debt ceiling less debt subject to limit $ bn • Stimulus spending, both from the 2009 Recovery Act and from subsequent extensions, continues to decline, 2500 • Military spending is set to decrease, particularly as operations in Iraq and Afghanistan wind down. 1500 In sum, we do not see the doomsday scenario playing out: policymakers are unlikely to drive the US economy off the fiscal cliff. Nonetheless, fiscal policy will continue to be a drag on the economy next year. The next section describes the fiscal issues that must be confronted at year-end. The following section discusses various political outcomes and how they will affect the choices made with respect to the year-end issues. The final section discusses fiscal issues other than the year-end ones. I: Head-first into the fiscal meat grinder The fiscal issues facing the economy early next year can be divided into four subcategories: expiring Bush tax cuts, expiring payroll tax and unemployment benefits, automatic budget cuts associated with the Budget Control Act, and the “usual” expiring provisions: AMT, “doc fix,” business tax extenders, etc. We discuss each in turn below. Bush tax cuts: The “sunsetting” of the Bush tax cuts is set to raise income tax rates across all income levels in 2013. For 2012, marginal tax rates ranged from 10% to 35%. If 2 2000 1000 500 0 05 06 07 08 09 10 11 12 13 Income tax rates for 2012 Single Up to $8,700 $8,701 to $35,350 $35,351 to $85,650 $85,651 to $178,650 $178,651 to $388,350 Over $388,351 Taxable income Married, filing jointly Up to $17,400 $17,401 to $70,700 $70,701 to $142,700 $142,701 to $217,450 $217,451 to $388,350 Over $388,351 Marginal tax rate 10% 15% 25% 28% 33% 35% Income tax rates for 2013, current law Single Up to $35,350 $35,351 to $85,650 $85,651 to $178,650 $178,651 to $388,350 Over $388,351 Taxable income Married, filing jointly Up to $70,700 $70,701 to $142,700 $142,701 to $217,450 $217,451 to $388,350 Over $388,351 Marginal tax rate 15% 28% 31% 36% 39.6% JPMorgan Chase Bank NA, New York Michael Feroli (1-212) 834-5523 michael.e.feroli@jpmorgan.com Economic Research US: fiscal cliff notes April 26, 2012 sunsetting occurs as currently scheduled, marginal tax rates will range from 15% to 39.6% in 2013 (tax rates by income bracket are detailed in tables on the right). How big are the Bush tax cuts? Along with the changes in income tax rates, there are several other changes associated with the Bush tax cuts that are currently set to occur in 2013. The Federal Child Tax Credit will revert from $1,000 to $500 per child for eligible families. The maximum tax rate for long-term capital gains will be raised from 15% to 20%, and there will no longer be a distinction between ordinary and qualified dividends (effectively raising the tax rate on dividend income to the ordinary income tax rate). There are a few tax provisions related to married couples filing jointly that will also expire. And the phasing out of personal exemptions and itemized deductions that were eliminated by the Bush tax cuts will resume in 2013. The size of these tax cuts is discussed in the box to the right. For calendar year 2013, the hit to disposable income on an accrual basis from the sunsetting of the Bush tax cuts could be around $280 billion, which is almost 2% of GDP. If such an increase in taxes were anticipated to be permanent (which seems more likely than in the case of the “temporary” payroll tax holiday), then the impact on spending would be larger. Even assuming a multiplier of two thirds, which is at the lower end of the range of estimates, the hit to consumer spending would be around $190 billion, or about 1.25% of GDP. Payroll tax and unemployment benefits: We lump these two different issues together because historically they have been legislatively linked. The 2%-point reduction in employee payroll taxes was initially a one-year tax holiday that took effect at the beginning of 2011. At the end of last year the tax holiday was extended another year, and now is once again set to expire on New Year’s Day. The payroll tax holiday gives the average American about $1,000 per year in extra spendable income. At an aggregate level it amounts to about a $125 billion annual lift to disposable incomes. While some of this extra income may be saved or used to pay down debts, our estimate—based on prior academic studies—is that about two thirds goes to increased spending. Thus, the payroll tax holiday may be supporting consumer spending by about $80 billion, or around 0.5% of GDP. Emergency unemployment compensation (EUC) was first passed into law in 2008 and was designed as a supplement to the regular 26 weeks of benefits available in most state unemployment insurance schemes. EUC has been expanded and extended numerous times in the four years since it was created, most recently it was reauthorized A variety of numbers have been circulated as to the size of the Bush tax cuts. Most estimates key off of the calculations performed by the CBO—the well-respected nonpartisan arbiter of fiscal issues. However, some care needs to be used in interpreting its various estimates. For example, the CBO estimates that the sunsetting of the Bush tax provision would only widen the deficit by $107 billion in fiscal year 2013. However, translating this into an economically useful number requires at least three considerations. First, the $107 billion figure does not account for the interaction of the Bush tax cut with the AMT patch. Should the AMT be patched—which we think is the overwhelmingly most likely outcome—then the amount by which individuals get “whacked” by the expiration of the Bush tax cut increases a lot. By the CBO’s estimate if the AMT were patched, the expiration of the Bush tax cuts would cost US households $143 billion in fiscal year 2013, on a cash basis. Second, the figures above are fiscal year measures, meaning the first three quarters of calendar year 2013. Since individuals pay income tax on a calendar year basis, the above numbers need to be scaled up by 4/3 to arrive at a calendar year equivalent: this translates the above figure to $191 billion for calendar year 2013. Third, these numbers are on a cash accounting basis. However, the sunsetting of the Bush tax cuts means individuals would accrue taxes at a higher rate during 2013, even if those taxes aren’t paid out on a cash basis until the April 2014 tax season. An example here is estate and gift taxes, almost all of which, should the Bush tax cuts expire, would be paid in early 2014 rather than during 2013. The economically relevant concept—both behaviorally and in the NIPA data—is the accrual rather than cash concept. Once one includes accruals that would be paid out in early 2014, the hit to household disposable income in 2013 from the expiration of the Bush tax cuts is probably around $280 billion. The size of the Bush tax cuts in 2013 $ bn Fiscal year, cash basis Fiscal year, cash basis, with AMT patch Calendar year, cash basis, with AMT patch Calendar year, accrual basis, with AMT patch $107 $143 $191 $280 Source: CBO 3 JPMorgan Chase Bank NA, New York Michael Feroli (1-212) 834-5523 michael.e.feroli@jpmorgan.com through the end of this year. Currently there are about three million beneficiaries receiving EUC payments, which have recently been paid out at an annual rate of around $45 billion. Unemployment benefits are probably even less likely to be saved or used to pay down debt than temporary tax cuts, and so by our estimate may be lifting consumer spending by around $40 billion, or just under 0.5% of GDP. EUC and a companion program, extended benefits (EB), are funded through year-end, though the latest authorization has begun to reduce the generosity of the benefits. Budget Control Act: The debt ceiling fiasco in the summer of 2011 was resolved with the Budget Control Act (BCA), which tasked the so-called Supercommittee with finding $1.2 trillion of deficit reductions over the ensuing 10 years. When the Supercommittee failed to come to an agreement, the BCA stipulated automatic federal spending cuts (or sequestrations) of $100 billion per year beginning in early 2013. Before we discuss how we think this plays out (in the next section), we first list the possible options for the BCA outcomes: • Current law is overturned. With simple majorities in both chambers of Congress, the sequestration procedure can be overturned, and there would be no cuts in 2013. Since this would likely face a filibuster in the Senate, realistically it would require 60 votes in that chamber to pass. This is the outcome that would likely produce a US debt downgrade; whether that has any real impact on the economy is debatable. A related outcome is that current law is completely replaced; presumably for this to avoid a downgrade the replacement would have to be equally austere. • Current law is allowed to run its course, and sequestration is activated in early 2013. The sequestration would reduce spending in that year by about $98 billion, with defense taking half the hit, and domestic discretionary spending and Medicare taking the other half. This outcome could reduce GDP by about 0.6% next year. • Between now and the beginning of 2013 Congress finds some of the $1.2 trillion in deficit reductions in the 10year horizon, thereby eliminating or at least blunting some of the impact of the 2013 sequestration. Note that if Congress gets “partial credit,” i.e., finds some, but less than $1.2 trillion, in deficit reductions, then there are two paths that can be taken. The deficit reductions could reduce the sequestration in 2013, or, the deficit reductions could push back the sequestration to the following year (provided the partial credit earned is for at least $98 billion in deficit reductions). 4 Economic Research US: fiscal cliff notes April 26, 2012 Maximum duration for unemployment insurance benefits Weeks Regular benefits EUC (all tiers) Extended Benefits Total Through May 26 53 20 99 Through August 26 53 Through December 26 47 79 73 This table represents the maximum possible duration across all states anticipated by Congress during the passage of The Middle Class Tax Relief and Job Creation Act of 2012. Individual states have different rules regarding unemployment insurance and certain programs can be triggered on or off in states depending on specific economic conditions. Persons receiving Extended Benefits and EUC benefits 000s, nsa, both scales 1000 6000 800 5000 600 4000 Extended Benefits 3000 400 2000 200 0 2008 1000 EUC 0 2009 2010 Usual expiring provisions: The three issues listed above—Bush tax cuts, payroll tax and unemployment benefits, BCA—are all fairly unique to this year. In addition, there are several fiscal policy issues coming up at year-end that usually come up. First, the Alternative Minimum Tax (AMT) must be “patched” in order to prevent 30 million middle class taxpayers from getting hit with the higher AMT rate. Second, Medicare reimbursements need to be adjusted with another short-term “doc fix.” Third, expiring business tax credit such as the R&D tax credit need to be extended; many of these have already lapsed so they will also need to be extended retroactively. All three of these measures are popular, enjoy bipartisan support, and have routinely been extended in recent years. We expect this time around will be no different and do not consider these programs to be part of the unique “fiscal cliff” issues facing lawmakers at the end of 2012. The remainder of this note assumes these measures are extended. Summing up GDP impact: If there were no changes to current legislation, the fiscal cliff impact on GDP growth next year (excluding the usual expiring provisions) adds up to a 2.75%-point drag. Moreover, this is probably an understatement, given our use of fairly conservative multipliers. Given the economy has averaged 2.5% growth so far in this expansion, its not hard to see that this could be a major problem. The next section discusses how the political class may respond to this situation. JPMorgan Chase Bank NA, New York Michael Feroli (1-212) 834-5523 michael.e.feroli@jpmorgan.com II: The 2012 political season To have a view on the economy in late 2012 and on into 2013, one needs to have a view on how the impending fiscal issues are resolved, and to have a view on how the fiscal issues are resolved, one needs to have a view on the outcome of the 2012 general elections. We are not political experts. Moreover, as Daniel Kahneman persuasively demonstrates in his recent best-seller Thinking, fast and slow, even political experts have very limited success in predicting political outcomes. With that in mind, we look at different scenarios for the outcome of the November elections, first focusing on the fate of the Bush tax cuts. In all cases the current White House and Congressional composition will need to reach at least a temporary agreement to get past the New Year. Obama reelected, GOP holds House, gains majority (though not super-majority) in Senate. According to the betting, or prediction, markets (e.g., Intrade, Iowa Electronic Markets), this is the most likely outcome. In this case, all participants at the bargaining table agree that the Bush tax cuts applicable to those making under $200,000 should be extended. The Republicans also want to extend the upper brackets, thereby leaving the current tax code intact, whereas Obama would seek to raise the upper brackets back to pre-2001 levels. In this case, the simplest solution is to extend the current tax code for another year or two. Indeed, a very similar setup confronted legislators in late 2010, when the Bush tax cuts were originally scheduled to sunset. The showdown was resolved by extending the tax code for another two years. In that episode the concession the Republicans made for the extension of the upper brackets was the payroll tax holiday and extension of unemployment benefits. It is likely that a similar concession would accompany an extension of the Bush tax cuts at the end of this year. One risk to this outcome is that Obama has stated that he would never again extend the upper-income brackets. Of course, bluffing is common practice in brinksmanship, but the key question is which party can outmaneuver the other in assigning blame for a failure to extend the Bush tax cuts. Realistically the party that is most stubborn in the negotiations will likely get saddled with the blame. For Obama to hold out to “merely” get upper-income tax hikes—which amount to about a quarter of the overall revenue produced by sunsetting the Bush tax cuts—would likely prove to be a risky strategy for the President. (Similarly, for the Republicans to hold the popular middle-class tax cuts hostage to getting their way on other legislation would also be dangerous). In short, we don’t think either side of the table has Economic Research US: fiscal cliff notes April 26, 2012 Intrade odds for Presidential election %, daily closing price 80 Obama elected 60 40 Republican elected 20 0 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Intrade odds for Congressional elections %, daily closing price 100 90 80 Republicans control Senate 70 60 Republicans control House 50 40 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Intrade ascribes a small probability to the possibility that neither the Republicans nor the Democrats control the Chambers of Congress. appropriate incentives to follow the “nuclear” strategy of allowing all of the tax cuts to expire and sink the economy back into recession. Obama reelected, Democratic Congress. According to polls, Democrats face an uphill battle in taking the House, or even in defending the Senate. Were they to do so, however, it is clear that the upper brackets would revert to pre2001 levels. This would imply a reduction in household income of around $60 billion (this figure would be added to the already-scheduled $20 billion reduction in disposable income due to the new Medicare tax set to begin next year as part of the Affordable Care Act). Given the current Republican control of Congress, the increase in taxes may need to take place retroactively, after Inauguration Day, as also happened in 1994. Some of this drag could be offset by higher social spending elsewhere. Romney wins, Republican Congress. In this scenario, the Bush tax cuts would certainly be extended, most likely retroactively after Obama leaves the White House in late January. Romney has recently campaigned on reducing income tax rates even further, though this seems to be a relatively recent rhetorical addition aimed at GOP primary voters. In this scenario the payroll tax cut and extended unem5 JPMorgan Chase Bank NA, New York Michael Feroli (1-212) 834-5523 michael.e.feroli@jpmorgan.com Economic Research US: fiscal cliff notes April 26, 2012 ployment benefits would likely be gradually phased out, implying a reduction in disposable income similar to the previous outcome. As with the case above, the change in tax legislation would probably take place after the inauguration, and the additional fiscal drag could be offset by a more generous tax code. Contributions for government social insurance, domestic Romney wins, Democratic Congress. This would certainly be an odd turn of events. While there are differences with the diametrically opposed case of Obama winning and Republicans taking Congress, we suspect the outcome might not be all that different—a failure to agree leads to a continuation of the status quo, though this outcome probably raises the odds of upper-income rate hikes. BCA—pain all around The resolution of the BCA requirements will also of course depend on the outcome of the November elections, though how the issue is navigated will largely be a Congressional matter, with only limited White House involvement. The first possible outcome (of the three BCA scenarios listed earlier) is that Congress simply overturns the BCA. Policymakers understand that the rating agencies would react negatively to the repeal of BCA unless it were replaced with a similar deficit reduction measure. Moreover, there are probably enough deficit hawks in the Senate to prevent this from happening without the need for a 60-vote majority. For these reasons, we think it is unlikely that the BCA will simply be overturned by Congress. The second scenario is that BCA is left to run its course, and funds are automatically sequestered from defense and nondefense spending programs. Such an outcome would reduce defense spending by about 10% and Medicare and domestic discretionary spending by about 8%. The hit to the Department of Defense, at a time when defense capabilities are already being stretched fairly thin, has led to considerable concern on the part of Congressional Republicans. This GOP opposition to the defense sequestration is the main reason that we do not foresee the full sequestration taking place, and their concerns will be complemented by Democratic displeasure with the prospect for such large reduction in domestic spending programs. We believe the third scenario, Congress gets “partial credit,” is the most likely outcome. There are a few measures that have received some bipartisan agreement in the past that could reduce the sequestration amount while still putting off most of the tightening until a later date. For example, using the chained-CPI for indexing Social Security and other benefits would produce a $200 billion savings 6 $ bn, saar 1000 950 900 850 05 06 07 08 09 10 11 12 13 Income from government unemployment insurance benefits $ bn, saar 200 150 100 50 0 05 06 07 08 09 10 11 12 13 over 10 years, with most of the spending reduction taking place in the back half of the planning horizon. Some of the pain of sequestration could also be averted by the use of budget “gimmicks,” such as counting the savings from a realistic drawdown of troops in Afghanistan. Deficit hawks oppose such fiscal voodoo, but such tricks may be necessary to reduce the amount of actual sequestration that takes place next January to a more tolerable size. Our baseline is that total sequestration that takes place next year is in the $20-$40 billion range. Payroll tax and unemployment benefits The payroll tax holiday faces opposition from fiscal hawks, while emergency unemployment compensation has met with resistance from some within the Republican party. Even so, these programs were extended by the Republican House late last year, even though the Democrats and the Administration had no bargaining chips. Evidently fear of being blamed for ending these relatively popular programs led the Republican leadership to blink at the last moment. The extension of these programs highlights the difficulty a Republican Congress may face in going cold turkey on these two programs. Of course, if Obama is reelected it may be even more difficult, as extending these two measures—which generally benefit lower and middle income JPMorgan Chase Bank NA, New York Michael Feroli (1-212) 834-5523 michael.e.feroli@jpmorgan.com households—may be the price a Democratic administration extracts in order to go along with an extension of the Bush upper-income tax rates. In fact, just such a compromise was how the payroll tax holiday was originally agreed to in late 2010. Our own expectation is that most, but not all, of these two programs will be extended. If they are extended, it would likely be in the context of reduced generosity of unemployment benefits, or perhaps lowering the payroll tax holiday to 1%-point instead of 2%-points. In sum, our baseline expectation is only limited drag from the gradual removal of fiscal lift provided by these measures. To be sure, this is the area of the fiscal cliff where the risk is greatest that we end up with more tightening than we foresee. III: Looking beyond the cliff Current discussion of fiscal policy understandably focuses on the year-end fiscal cliff issues. However, in order to construct a holistic view of the impact of fiscal policy on the US economy, a few points should be made regarding non-cliff fiscal issues. In particular, even with the relatively benign scenario laid out above, there are two aspects where fiscal policy will likely remain tight: Economic Research US: fiscal cliff notes April 26, 2012 Fiscal stimulus FY, $ bn ARRA Non-ARRA Total stimulus funds Change in stimulus funds % of GDP 2009 177 0 177 177 1.3 2010 323 92 415 238 1.7 2011 171 266 437 22 0.1 2012 39 247 286 -151 -1.0 2013 44 152 196 -90 -0.6 ARRA: American Recovery and Reinvestment Act of 2009 Defense outlays % of GDP Forecast 5.0 OMB 4.5 4.0 3.5 CBO, assuming troops in Mideast operations down to 45,000 by 2015 3.0 2.5 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 Change in defense outlays • The winding down of stimulus outlays related to the 2009 Recovery Act as well as the numerous subsequent additional stimulus acts. % of GDP Forecast 1.0 0.5 • The anticipated decline in defense outlays, partly related to the wrapping up of operations in Iraq and Afghanistan. 0.0 Fading of stimulus -0.5 Stimulus occurs when policymakers actively make choices to change policy in order to provide more fiscal support to the economy. The most notable example in the current cycle is the 2009 Recovery Act, or ARRA. Not all of ARRA should be considered stimulus, however, as some components—such as patching the Alternative Minimum Tax to prevent a large middle-class tax hike—occur every year. The only reason the AMT is not permanently extended is so that Congress can preserve an accounting mirage. For this reason, we exclude these “extenders” in the stimulus table on this page. More important for understanding the outlook is to remember that not all stimulus measures undertaken in the current cycle were contained in ARRA. Perhaps the most prominent such measure is the payroll tax holiday, which was initially conceived to offset the tax hike that took place when the Making Work Pay tax credit—which was part of ARRA—expired at the end of 2010. However, in the years since the recession there have been numerous other smaller legislated changes to tax and OMB CBO, assuming troops in Mideast operations down to 45,000 by 2015 -1.0 80 85 90 95 00 05 10 15 spending policy to support the economy, including extending unemployment benefits, COBRA health coverage benefits, state fiscal relief, etc. A recent tabulation by the Center for Budget and Policy Priorities places the bill for these non-ARRA stimulus measure over the 2009-2013 period at $640 billion, almost as much as the ARRA stimulus measures impact on deficits over the same period, which is about $754 billion. Even with the recent extension of the payroll tax holiday, the amount of support provided to the economy through discretionary fiscal actions is set to contract this year, which will be a headwind to growth. The total amount of stimulus-related outlays and tax expenditures will contract by about 1% in fiscal year 2012. The exact multiplier effect of this financial measure on GDP is uncertain, but using a 7 JPMorgan Chase Bank NA, New York Michael Feroli (1-212) 834-5523 michael.e.feroli@jpmorgan.com Economic Research US: fiscal cliff notes April 26, 2012 fairly standard multiplier of 1.0 would imply that the waning of stimulus could subtract about 1%-point from growth this year. Changes in defense outlays have been dominated by noneconomic considerations, and so they are not included in the above calculations, which measure the fiscal policy response the Great Recession. One potential offset is that some of these expenditures go to foreign nationals for services provided in the theater of operations. In the economic accounts, these purchases are considered imports. Such “imported” defense expenditures are less than $30 billion, whereas the decline in defense spending over the next few years will likely amount to over $100 billion. So even if defense imports fell to zero, this offers only a partial offset to the domestic drag that is set to occur from reductions in defense outlays. A farewell to arms Most discussions of how fiscal policy relates to the outlook rightly focus on the discretionary stimulus measures. However, there are other moving parts when it comes to fiscal policy. One that will become increasingly important for the US economy is defense spending. The winding down of military operations in Iraq and Afghanistan could contribute to a decline in defense spending of about 1/4%-point of GDP this year, and then a contraction of about 1/2%-point in both 2013 and 2014. The regional recessions in California and New England in the early 1990s serve as a reminder that welcome foreign policy developments can sometimes be accompanied by painful economic transitions. Estimating the impact of these developments is made a little more difficult by the fact that the CBO’s baseline estimate for these Overseas Contingency Operations (OCOs) must assume a continuation of the troop levels in the prior fiscal year, even though most observers expect the ongoing drawdown of troops in the Mideast will continue. To allow for this possibility, CBO also constructs an alternative scenario whereby troops in that region are gradually decreased, and in that scenario defense spending declines in a similar manner to that in the OMB forecast—which is allowed to make more realistic assumptions concerning defense policy. And in summation... The first two sections of this note discussed the fiscal cliff and our expectation that only a fraction, perhaps one-fifth, of that cliff will be realized. The last section discussed noncliff issues, focusing on fading stimulus and declining defense spending. The table at the bottom of the first page puts this all together into one measure of the expected impact of fiscal policy on the economy. In order to translate deficits into fiscal thrust, one needs to remove the swings to the deficit caused by automatic stabilizers, where changes reflect economic developments. In addition, TARP outlays (on a subsidy cost basis) reflect financial rather than real transactions and should be removed. Changes in the resultant structural deficit represent the fiscal thrust or drag from federal fiscal policy. We have mostly avoided the issue of fiscal multipliers, but applying a fairly middleof-the-road multiplier of 1.0, the table implies a drag of 1.4% on GDP growth next year. Of course, if the cliff is not dealt with the drag could be more than twice as large. 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Any offer or sale of the securities described herein in Canada will be made only under an exemption from the requirements to file a prospectus with the relevant Canadian securities regulators and only by a dealer properly registered under applicable securities laws or, alternatively, pursuant to an exemption from the dealer registration requirement in the relevant province or territory of Canada in which such offer or sale is made. The information contained herein is under no circumstances to be construed as investment advice in any province or territory of Canada and is not tailored to the needs of the recipient. To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securities commission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein or the merits of the securities described herein, and any representation to the contrary is an offense. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul branch. Revised April 18, 2012. Copyright 2012 JPMorgan Chase Co. All rights reserved. Additional information available upon request. 8