The Dinner Party and the Fiscal Cliff Last week my wife and I joined several friends for

dinner to celebrate a birthday. The dinner conversation evolved as most do; our kids activities of the day, baseball playoffs, and the antics of my youngest son. Not surprisingly the conversation eventually turned to the election, with most of the attention focused on the Presidential ticket. Aside from the usual comments about one candidate vs. the other, there was a genuine concern about the economy and the country's fiscal challenges. The upcoming combination of tax and spending changes, dubbed the "Fiscal Cliff", that will go into effect on January 1st could remove as much as 4% from GDP, was the topic that garnered most of the attention. It is no secret that neither political party wants to see this happen, nor will either benefit from the economic disruption of such a large fiscal headwind. Both sides do have their preferred programs and ways to minimize the impact of the cliff, but finding middle ground in Washington has proven difficult in recent years. The Presidential election is about as close as it gets and many indicators point to a dead heat. Absent a major gaffe or other unpredictable development, the presidential race looks like it will go down to the wire, perhaps with a split between the popular vote and the Electoral College vote. With the national polls appearing to slightly favor Governor Romney and as noted by Daniel Clifton of Strategas Research Partners, we have often noted that historically undecided voters start to make up their minds around mid-October in previous presidential reelection years it seems that Romney is the slight favorite to win the popular vote. Yet President Obama looks as if he has a small lead in Ohio, the state that many experts think is most likely to put the winner (whoever it is ) over-the-top in the Electoral College. The incumbent Presidents approval rating has proven a good indicator to determine the percentage of the two party vote total received in the general election, and a rating above 50% bodes well for the incumbent. We are now watching the real clear politics average in which the president is just below 50%. (Link) Barring an October surprise, it looks like neither candidate will emerge with a clear mandate (either in the Electoral College, or from the popular vote) for their proposals. If that ends up being the case, we need to turn to the congressional

races to identify who will have the influence to resolve the fiscal cliff and in what manner those individuals will be able to resolve the fiscal cliffraising the question, does it really matter who wins The Whitehouse?

The Senate seat count may prove far more important than the top of the ticket. The ability of the either candidate to pass a meaningful agenda for avoiding the fiscal cliff will likely depend heavily in the balance of power in the Senate. According to the Real Clear Politics average of Senate race polls the seat count stands at 47 for the Democrats and 43 for the Republicans, with 10 races too close to call. (Link) At this point the math doesnt favor either party gaining a filibusterproof majority, and with 51 seats needed for a simple majority, it will be difficult for the Republicans to gain controlbarring a significant surprise. The House of Representatives seems likely to remain in Republican hands (although with fewer seats), with the Real Clear Politics seat count at 183 for the Democrats and 226 for the Republicans, and 26 toss-ups. (Link) All this could make for a contentious lame duck session depending on the outcome of the Presidential and Senate elections. According to Andy Lapeer of International Strategy and Investment (ISI), the odds there is a deal in the lame-duck session are about 50/50 if Romney wins and 60/40 if Obama wins. Thus, the combination of a President Romney and a Democrat Senate could lead to a longer (and more contentious?) path to a resolution of the January 1 cliff.

Obviously, almost no member of Congress (or the president, whoever he is) would want to see a massive fiscal tightening that most economists predict would be large enough to push the nation into a recession and push-up the, already high, unemployment rate. Going over the fiscal cliff would involve massive tax increase that would substantially reduce the take-home pay of almost all workers. Many members of Congress, especially Republicans, would be concerned that the huge cuts that the congressional sequester would force at the Pentagon would substantially degrade American military power. Likewise, many members of

Congress, especially Democrats, would have concerns that the sequester would cut deeply into a wide range of domestic programs and of course all members of Congress will likely be concerned that they would be blamed for any of these developments. If President Obama wins, it seems likely he would veto a full extension of the Bush tax cuts, given prior statements and press accounts by his administration. The key is whether there is a deal to be made and if he is willing to compromise on his $250,000 figure. If he is, he can probably split the Republicans in the Senate and pass compromise of some sort. Is there hope for a compromise? While recent congressional inaction and the partisan rhetoric might suggest a compromise on the Fiscal cliff before year-end is unlikely, a compromise after the election looks plausible if each item of the fiscal cliff is considered independently. According to the table below, Republicans and Democrats actually agree on many of the fiscal cliff items.
P rovision Bush Tax Cuts For $250K=(includes estate tax) Bush Tax Cuts For < $250k AMT Payroll Tax Cut Unemployment Insurance Affordable Care Act (3.8%on dividends/cap gains; 0.9%on wage income for $250k+ ) Sequester -Defense Sequester-non Defense Discretionary Sequester-Mandatory (Medicare= other) tax extenders (R&D tax credit, other) Doc Fix(Medicare reimbursement) TOTAL FISCAL DRAG %OF GDP E tim tedC 2 1 ($ n) s a Y 03 B $55 $155 $130 $110 $35 $25 $55 $38 $16 $85 $15 $719 BN 4.50% Avera e R g epublica Position n Extend Extend Extend No Extension No Extension Repeal Repeal Implement Implement Extend Extend Av g D ocra P ition era e em t os Do not extend Extend Extend No Extension No Extension Implement on schedule Partly repeal Repeal Repeal Extend Extend

Source: CBO, Center on Budget and Policy Priorities, Congressional Research Services, Peterson Institute for International Economics, PIMCO 1. While the President and Democrats have supported these provisions historically, they were not included in the Presidents recent budget nor in the recent Senate taxlegislation.

The biggest area of disagreement is whether the Bush income tax cuts for families making more than $250,000 should be extended. However, while the Democrats seem firmly opposed to extending income tax cuts for high wage earners, they have shown some willingness to compromise on capital gains and dividend taxes, most recently by sponsoring a plan this summer that would set dividend and cap gains

both at about 20% for high wage earners instead of letting dividends revert to ordinary income, or 39.6% for high wage earners. (Link) Similarly, there is some incentive for both sides to find a way to address these items. The Budget Control Act, the deal that resulted from the 2011 debt ceiling debate, imposes $110 billion of cuts in 2013 equally across defense and nondefense programs. This is effectively represents an across-the-board cut from domestic discretionary spending of 8.5% and, 10% from defense spending for calendar year 2013. This sequester trigger was designed to be undesirable to Congress, and was supposed to encourage them to find cuts on their own via the Congressional Super Committee. But following the failure of that committee last year, Congress is stuck between a rock and a hard place, providing additional incentive on both sides of the aisle to find a way outeven if it is only a temporary one. On most other items, there is relatively clear agreement; both sides will likely support an extension of the AMT patch and the doctor fix, and both will support an extension of the pro-business tax breaks. The issues of the 2% payroll tax cut and unemployment insurance, where both parties have typically disagreed historically, there now seems to be a consensus - neither the White House nor Democrats in Congress seem to be pushing for these provisions to be extendedat least for now.

The pressure to act on the fiscal cliff is mounting. After the election is over, it will probably move to the forefront of the news cycle. We see relatively easy compromises on most items, except the Bush tax cutsCongress wont be able kick the can on that issue. Someone has to give in on the Bush tax cuts, which is why it is such a difficult issue to solve. After considering the backdrop in-full, we find some cause for tempered optimism for some resolution of the Fiscal Cliff in the lame duck session. While it seems unlikely that the all the issues will be resolved, and that some may receive only a temporary fix, it looks like we will see most of these items addressed in December and January (at least in total dollar terms). The two parties appear to agree on all but ~$189 billion of the Fiscal Cliff items. This represents about 1.2% of U.S. GDP, much less than the 4% as a whole. However 1.2% is a significant figure given the 2% GDP growth for the 3rd quarter of 2012. The broader economy has shown some signs of life this fall, and the prospects for the second half of 2013 look moderately

promising, consensus estimates for 3rd and 4th quarter GDP in 2013 are 2.5% and 2.7%, respectively. We believe that any disruptions that arise from the election outcome and the debate over the fiscal issues will be temporary, and that given some clarity following the election, businesses and consumers may feel a bit more confident in the direction the country will take in the next 4 years.