An Election of Social Issues Not Fiscal IssuesAmerica has voted and the results are in. Going into November 6th, pundits and pollsters alike cited the economy as the key factor that voters would focus on. The reality was an election focused on social issues as opposed to the tough economic and budget issues facing the nation. The result is that we maintain the same partisan environment for at least the next two years. The focus now shifts towards the impending fiscal cliff of tax increases and spending cuts. The uncertainty about the future path of spending and tax policy will continue to weigh on economic growth as Congress attempts to strike a longer-term deal (top graph).
Based on the results of the election, we continue to expect a short term continuing resolution which kicks the can down the road to the next Congress (60 percent probability). After the first of the year look for both parties to sit down and work towards a longer term agreement which will most likely consist of some modest tax increases and some modest spending reductions within a framework for long-term deficit reduction. The tax increases will include the expiration of the payroll tax cut, extended unemployment benefits and the corporate “bonus” deprecation tax credit. We expect some cuts to defense spending and modest cuts to non-defense spending but these cuts will be watered down. Given the ongoing divisiveness within Congress we have increased our probability that the nation goes over the fiscal cliff (40 percent probability). The absence of clear direction from the electorate on economic policy and long-term fiscal policy will make it more difficult, but not impossible, to come to a short term deal. The challenges that policy makers face over the next several months are immense. Tax reform is likely the single biggest challenge facing policymakers due to the existing imbalance in who pays taxes (middle graph). A bipartisan deal will need to include some form of entitlement cuts along with tax reform that increases the total number of taxpayers along with raising rates.