US Reaches Eleventh-Hour Deal to Avert ‘Fiscal Cliff’

Global stock markets have risen following news that the US Congress had approved legislation to avert the so-called ‘fiscal cliff’ of swingeing across-the-board tax increases and spending cuts that would otherwise have come into effect on 1 January 2013.

Following months of negotiations between Democrats and Republicans, the House of Representatives passed the bill by 257 by votes to 167. The deal agreed will restrict tax increases to those earning US$400,000 or more annually and leave rates for the middle class untouched. The Democrats had originally lobbied for a lower figure of US$250,000.

In the absence of a deal, around US$600bn worth of automatic tax hikes and spending cuts – collectively dubbed the fiscal cliff – would have been triggered at the start of this month, threatening to tip the US economy back into recession.

Relief that this scenario has been averted is offset by concerns that while the vote has averted immediate tax hikes for almost all US households, it has not resolved the issue of spending cuts, but only delayed them for two months.

President Obama welcomed the agreement, but said that the US deficit was still too high. While open to compromise on budgetary issues, he would not offer Congress spending cuts in return for lifting the government’s borrowing limit, known as the US debt ceiling.

The White House now faces a new deficit deadline of 1 March, leaving only two months for Republicans and Democrats to reach a further accord on where spending cuts will fall. “There is a path forward, if we focus not on politics, but on what’s right for the country,” said Obama.

In addition to higher income tax rates for the wealthy, the package includes:

  • Rises in inheritance taxes from 35% to 40% after the first US$5m for an individual and US$10m for a couple.
  • Rises in capital taxes – affecting some investment income – of up to 20%, although less than the 39.6% that would have applied in the absence of a deal.
  • A one-year extension for unemployment benefits for two million people.
  • A five-year extension of tax credits that help poorer and middle-class families. 

Commenting on the agreement, Mike Turner, head of global strategy and asset allocation at Aberdeen Asset Management siad: ” The tax rises agreed by the House of Representatives may have averted a near-term recession, but an economic crisis induced by the deteriorating creditworthiness of the US still looms.

“In essence, the compromise agreement raises taxes for the wealthy and delays spending cuts for two months. Without the passing of these measures tax increases of about US$536bn and spending cuts of US$109bn would have been triggered; the conseqiuences of which could have sent the US back into recession and global markets tumbling.

“Yet while the consensus reached by the Democrats and Republicans has avoided a politically-initiated crisis, there is still much work to be done. The tax rises implemented are arguably only the small part of the equation. The real tough decisions centre on government spending. The US deficit remains too high, and despite the interest charged being extremely low action needs to be taken to address the unsustainable growth in federal debt. Spending cuts are required, but they need to be balanced with incentives encouraging companies to invest some of the huge sums of cash on their balance sheets. In its simplest form this means certainty over the longer-term fiscal and growth outlook.

“Until a long-term plan is agreed, which reduces the annual budget deficit to less than 3% of gross domestic product (GDP), investors are likely to remain nervous.”

Didier Saint Georges, an investment committee member at the firm Carmignac Gestion, said that the ‘relief rally’ in equity markets in response to the news was fair. “However, a key question for investors remains whether the scope of this agreement is large enough to trigger the long-awaited upturn in the industrial investment cycle, which will support the US economic recovery,” he added.

“Since mid-2012, US corporates have been holding off investments for lack of visibility on the budget negotiations. And, unfortunately, the visibility has not improved much at all after this agreement. If anything, the real cliff is only coming now, with a debt ceiling which has already been reached and urgently needs to be negotiated up.

“Brinkmanship is likely to prevail again, which could further delay corporate confidence. Some caution is warranted from current market levels as the US consumer is likely to remain the main and fragile growth engine for the US economy in the short term.”

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