At the end of this year, the Bush era tax cuts are scheduled to expire. At the same time, the one-year extension of the payroll tax cut is also scheduled to expire. Finally, federal spending is scheduled to be cut because the Super Committee failed to reach a budget compromise last November. If Congress does nothing and the tax increases and spending cuts take place as scheduled, the U.S. economy is likely to suffer, and could go back into recession. Fortunately, both political parties have indicated a willingness to avoid the fiscal cliff. However, their strategies are different. The Republicans would like to extend the Bush tax cuts for all taxpayers as part of broader tax reform. The Democrats would like to extend the tax cuts for most taxpayers, except high income taxpayers. Unfortunately, Congress is unlikely to resolve these differences until after the November elections. Once the outcome of the vote is known and the parties know what they have gained or lost, the winning party is likely to push its proposals. At this point, we do not expect the worst-case scenario to unfold. Instead, Congress is likely to delay or dilute the tax increases and spending cuts. Therefore, the U.S. economy is unlikely to go back into recession unless the election leads to further gridlock. Of course, the full economic impact will depend on the state of the global economy at that time, not just the U.S. economy. If the global economy is starting to strengthen, the fiscal cliff problems may not derail the U.S. economic expansion. Alternatively, if the global economy is still weak or weakening further, then the economic impact of the fiscal cliff would be greater.
Source: Wells Fargo Advisors