Friday, December 28, 2012

Santa Claus Rally Days 16 and 17 And The Fiscal Cliff

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courtesy of wikipedia creative commons licence
Decisions regarding the fiscal cliff will have meaningful implications for deficits, debt, and economic growth. The Congressional Budget Office (CBO) has projected two fiscal scenarios for the years 2013 to 2022:[19]

    The baseline projection, following current law. This scenario would have lower deficits and debt but also have lower spending and higher taxes.

    The alternative fiscal scenario, estimated as another option in which some laws are changed. This results in higher deficits and debt but lower taxes and higher spending.[note 3]

These paint starkly different fiscal futures. If Congress and the President do not act, allowing tax cuts to expire and mandated spending cuts to be implemented, the next decade will more closely resemble the baseline projection. If they act to extend current policies, keeping lower tax rates in place and postponing or preventing the spending cuts, the next decade will more closely resemble the alternate fiscal scenario.

Baseline projection. The CBO has been publishing baseline projections, following the then current law, since 1985.[18] Under the current baseline, tax cuts are allowed to expire and spending cuts are implemented in 2013, resulting in higher tax revenues plus reduced spending thus lowering deficits, debt and interest for the next decade and beyond. Future deficits would be reduced from an estimated 8.5% of GDP in 2011 to 1.2% by 2021. Revenues would rise towards 24% GDP, versus the historical average 18% GDP.[20]

The total deficit reduction or debt avoidance over ten years could be as high as $7.1 trillion, versus the $10--11 trillion debt increases if current policies are extended. In other words, roughly 70% of debt increases projected over the next 10 years could be avoided by allowing the expiration of tax cuts and required sequestration expected at the end of 2012 in the absence of new legislation.[21]

CBO estimates under the baseline projection that public debt rises from 69% GDP in 2011 to 84% by 2035.[22] In the long run, lower deficits and debt should lead to relatively higher growth estimates. But, in the short run, real GDP growth in 2013 would likely be reduced to 0.5% from 1.1%. This would mean a high probability of recession (a 1.3% GDP contraction) during the first half of the year followed by 2.3% growth in the second half.[23][24]

Alternate fiscal scenario. If Congress "avoids" the fiscal cliff, the future more closely resembles the continuation of 2012 policies as described by the CBO's "alternative fiscal scenario." This scenario involves extending the Bush tax cuts, repealing the automatic spending cuts, restricting the reach of the AMT and keeping Medicare reimbursement rates at the current level (the so-called "doc fix", versus declining by one-third). Revenues are assumed to remain around the historical average 18% GDP. Under this scenario, public debt rises from 69% GDP in 2011 to 100% by 2021 and approaches 190% by 2035. This scenario has considerably higher debt and interest payments than the baseline projection, but short-term impact on the economy is avoided.[22]
Projected effects