In a somewhat stunning turn of events, the House Republican leadership has decided to add $100 billion to the US deficit by passing a 10-month extension of a Social Security payroll tax cut without finding offsets to pay for it.
This comes within 24 hours of hyper-criticism (much deserved) of President Obama’s budget. (One of my favorite parts of the Obama budget is the use of a peace dividend stemming from ending the wars in Iraq and Afghanistan. Sounds great, until you realize that both wars were not paid for and therefore there is no honey pot of money to spend.) The move was apparently done to take away Democratic criticism that Republican intransigence would negatively impact 160 million Americans. The strategy appears to create a stand-alone bill for the payroll tax cut, then have another bill for the extension of unemployment benefits and a fix to the Medicare reimbursement rate for doctors.
At the core, the payroll tax cut is one of the worst possible tax cuts to use because it not only worsens the viability of Social Security, but also it’s a tax that is almost impossible to avoid paying. For the House Republicans, they may be able to salvage some fiscal credibility by ensuring that the “Doc fix” and jobless benefit extension are both paid for via spending cuts/tax hikes. Given that Republicans have caved on the payroll tax, it may be impossible to convince the rank and file members that the leadership will stick to a position of fiscal prudence on these other issues. Moreover, this move blurs the lines between the two parties and certainly will raise Tea Party questions over why to support the Republicans in a national election. It may help drive the call for Ron Paul to splinter-off, run as a third party candidate and effectively hand the election to President Obama.
Most importantly, this sets up a year-end train wreck for solving thorny, but critical issues on taxes for the lame-duck session of Congress. The ending of the Bush tax cuts for all taxpayers, the ending of corporate tax extenders and the ending of the payroll tax cut for 2012 will all be on the potential docket. This includes the capital gains tax rate going from 15% to 20% and the dividend tax rate going from 15% to ordinary income tax rate. The latter change would likely call into question all those equity market strategies that were based on high dividend payouts from companies as a means of creating income during a low interest rate environment. Along with the FOMC keeping rates at zero, this will be another way the government punishes domestic savers.
Beyond these negatives, the elephant in the living room remains the massive and ever increasing US debt and deficit. During President Obama’s tenure, the US budget deficits have been $1.4, $1.3, $1.3 and projected $1.33 trillion dollars. The debt has exploded from $10 trillion to $15 trillion. The US has been downgraded by S&P with Moody’s and Fitch expressing concerns over the long term debt of the country. Both parties are guilty of expanding the problem and both parties have yet to express leadership to find a path to compromise to solve the issues. President Obama’s budget and Republicans agreeing to cut taxes without cutting spending are emblematic of the problem.
The major point to take away is that both parties are in full election year mode and the deficit be damned. Both Democrats and Republicans better hope the markets don’t become rattled and reassert themselves as the arbiters of poor fiscal management. The truly cancerous problem will be the lack of economic growth and job creation that stems from mishandling these critical issues. For the markets, this condition will continue to fester and create heightened uncertainty as we head into the third and fourth quarters of 2012. We will likely see the markets react by building in a risk premium for a devolving US financial and tax environment. This means we could potentially see a reversal of the gains from the first half of the year.
Andrew B. BuschDirector,Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and