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US Fiscal Cliff - A Mountain Of A Molehill

| 11/15/2012 9:00 PM Thursday

The US ‘Fiscal Cliff ’ is the latest buzzword to have grabbed the attention of market participants. All the hype notwithstanding, it means very little for the Indian markets. Shashikant explains.

Till a few months back, the ‘Fiscal Cliff ’ with reference to the US economy was something which was discussed only in closed rooms and that too by a few policy makers and an inner circle of investment managers. Suddenly, in the last couple of weeks, the subject has come out of closed room discussions and has taken centre stage. Anyone even remotely associated with the stock markets or the investment world is today worried about the ‘Fiscal Cliff ’.

What is this ‘Fiscal Cliff ’ and does it really possess the potential of destabilising the global economy that is still limping due to the financial crisis that had happened in 2008 and the still persisting Euro zone problems?

The impact that the worries emanating from the whole ‘Fiscal Cliff ’ phenomenon have had on the US markets in particularly and in turn on the other markets worldwide including India is something that needs to be taken note of. Following these worries, the Dow Jones Industrial Average fell by 121.41 points on November 8 to 12811, its lowest close since July 25. This fall was on the back of a 313 point sell off on Wednesday (November 7, 2012), and put together, the 3.3 per cent decline marked the biggest two-session drop this year. So, what is the ‘Fiscal Cliff’ and how can it affect the US economy in general and the Indian economy and markets in particular?

In A Nutshell

The ‘Fiscal Cliff ’ is a situation where in order to bring down the burgeoning fiscal deficit in the US, a two-point agenda will be implemented from the midnight of December 31, 2012. One, the administration is all set to reinstate the taxes to their original rates as were prevailing before George Bush cut them. Second, a spending cut agreed upon as part of the debt ceiling deal in 2011 will begin to take effect. This proposal will help the government to cut down on expenditure to the tune of almost USD 2.1 trillion over the next decade. All this would bring down the fiscal deficit in the US by almost USD 600 billion in 2013 itself.

Rising Taxes
Income Tax Rates Rise to 15 per cent, 28 per cent, 31 per cent, 36 per cent and 39.6 per cent, up from 10 per cent, 15 per cent, 25 per cent, 28 per cent, 33 per cent and 35 per cent.
Capital Gains Rate
Rises to 20 per cent from 15 per cent for most filers
Qualified Dividend Rate Rises to one’s top income tax rate, up from 15 per cent for most filers
The Social Security Tax Rate Reverts to 6.2 per cent, up from 4.2 per cent on the first USD 110,100 in wages

The Implications

Although these measures (spending cut and tax increase) will help the US in bringing down its fiscal deficit, both measures will have a drastic impact on the GDP growth rate. The US economy, which is already showing signs of slowing down, may contract in 2013 if both the measures get implemented. The GDP growth rate of the US has come down from 4.1 per cent at the end of the fourth quarter of CY11 to two per cent for the third quarter of 2012. According to various estimates it may contract by anywhere between 0.5-2 per cent in 2013, following the implementation of both the above state measures. The reason for such a con- traction is the lesser disposable income that will be available with citizens.

If we analyse the US GDP growth rate, personal consumption expenditures has cumulatively  contributed 4.3 per cent to the GDP growth out of the total 6.8 per cent since the second quarter of 2009. In other words, 63 percent of the USD GDP growth is contributed by personal consumption expenditure. A major hit will come from the tax increase that is likely to cost around USD 532 billion and the remaining USD 136 billion could come from the spending cuts.

There is a possibility that all this can be avoided if a compromise is reached between the Congress and the White House. We believe that some sort of an agreement may be reached at, as was seen last year when the Democrats and the Republicans averted a debt default on 1st August, 2011, by agreeing to reduce spending by at least USD 2.1 trillion over 10 years.

 

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