June 20, 2012

Economics Group
Special Commentary
John Silvia, Chief Economist
john.silvia@wellsfargo.com (704) 374-7034

Michael A. Brown, Economist

michael.a.brown@wellsfargo.com (704) 715-0569

Sarah Watt, Economic Analyst

sarah.watt@wellsfargo.com (704) 374-7142

The Fiscal Cliff: Likelihood and Economic Impact

Markets are forward looking but are not looking forward to the fiscal cliff of 2013. Already, recent months data have shown slower employment growth, capital expenditures and government outlays, as worries over the fiscal cliffonly seven months awayhave begun to seep into private and public decision making. As we approach the second half of 2012, fiscal policy uncertainty will continue to build around the rapidly approaching fiscal cliff of significant tax increases and large government spending cuts that are set to take place beginning in January 2013. In our 2012 Annual Outlook,1 we noted that one of the major risks to our forecast was ongoing political uncertainty that would put downward pressure on consumer spending and business investment, and thus headline GDP growth. As the economic data have begun to unfold in the middle of this year, we are beginning to see the first signs that growth has begun to soften in response to that uncertainty. We attribute the bulk of the weaker economic data to deteriorating economic conditions globally; however, recent academic work has begun to provide evidence that increases in policy uncertainty can damage the economy.2 Thus, some have argued that the recent pullback in economic indicators may be attributed to increasing political uncertainty. This commentary provides our view on the net effect to our U.S. forecast in the instance Congress and the administration do not change the impending budget cuts and tax policy currently set to go into effect in January 2013. However, we believe the most likely scenario is that some policy will change. Therefore, we also discuss our view of the most likely scenario in which there is a continuation of existing tax and budget policies on a short-term basis. Beginning in January 2013, federal tax policy is set to tighten as a number of provisions passed in recent years, which have lowered taxes, are scheduled to expire. Among these are the Bush tax cuts, which were originally passed in 2001 and 2003 and extended several times, most recently, at the end of 2010 in conjunction with an extension of unemployment benefits and a reduction in the payroll tax. The expiration of the Bush tax cuts is estimated by some to produce a sizable increase in government revenue. Between fiscal 2012 and fiscal 2013, the Congressional Budget Office (CBO) estimates that the expiration of these cuts will lead to approximately $220 billion more in revenue.3 The first notable change to tax policy, leading to a marked rise in federal revenue, is a rise in the tax rate for the top four income brackets. The tax rate for the top bracket of income would be
Available at www.wellsfargo.com/economics, or upon request. For more evidence on the link between economic growth and political uncertainty see Baker, S. R., Bloom, N. and Davis., S. J. (2012). Has Economic Policy Uncertainty Hampered the Recovery? Chicago Booth Research Paper No. 12-06. Initiative on Global Markets. The University of Chicago, Booth School of Business. 3 Congressional Budget Office. Economic Effects of Reducing Fiscal Restraint that is Scheduled to Occur in 2013. May 2012.
1 2

As we approach the second half of 2012, fiscal policy uncertainty will continue to build around the rapidly approaching fiscal cliff.

What Policies Are Set to Go into Effect?

This report is available on wellsfargo.com/economics and on Bloomberg WFEC.

The Fiscal Cliff: Likelihood and Economic Impact June 20, 2012

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

moved higher from 35 percent to almost 40 percent, while the tax rate for the next three income brackets would each rise by three percentage points (Figures 1 and 2). Second, the lower rate of tax applied to the first $7,000 of taxable income for single filers ($14,000 for married joint filers) would increase from 10 percent to 15 percent. Third, the top rate for long-term capital gains would rise from 15 percent to 20 percent and dividends would be taxed as ordinary income. In addition, pending the decision from the U.S. Supreme Court on the Affordable Care Act, it is possible that an additional 3.8 percent capital gains tax would be added on top of the 20 percent for a total capital gains tax of 23.8 percent. Changes to the alternative minimum tax (AMT) would also likely give a boost to government coffers in the first half of 2013. Although changes to the AMT became effective in 2012, the government will likely not see an increase in revenue from this change until 2013 when taxes are filed for the year 2012. Figure 1
Top Marginal Tax Rate
100% Top Marginal Tax Rate: 2012 @ 35% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 13 23 33 43 53 63 73 83 93 03 13 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 100%

Figure 2
45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Top Bracket 2nd 3rd 4th

Top Income Tax Bracket Rates Before and After the "Fiscal Cliff"
2012 2013

45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

Source: Internal Revenue Service and Wells Fargo Securities, LLC

In addition to an increase in tax rates, numerous tax credits will be lowered or expire. Included is the child tax credit, which will decline from $1,000 to $500 per eligible child. The marriage penalty relief will also expire, with the deduction for married couples relative to singles falling and the higher phase-out level for the earned income tax credit expiring. Education benefits will also be reduced. For example, employer-provided educational assistance will be fully taxed as ordinary income, and stricter limits on student loan interest deductions will be put in place. Accelerated depreciation will also expire at the end of 2012, which would weigh on equipment and software spending in the first quarter of 2013. Besides the impact to individual income tax law changes, business tax law would also change. The partial expensing of investments in property or equipmentknown as bonus or accelerated depreciationwill also expire at the end of 2012, which would weigh on equipment and software spending in the first quarter of 2013. Outside of the Bush tax cuts, the expiration of the payroll tax credit will also raise government revenue. This measure reduced payroll taxes by two percentage points, effectively increasing workers take-home pay when first enacted in 2011. If allowed to expire in 2013, the CBO estimates that an additional $95 billion in revenue would be raised in fiscal 2013. In addition to a significant rise in revenue based on current tax laws, federal spending is also set to decline under current law in January 2013. The Budget Control Act passed last summer included a sequestration clause that would reduce government spending by $65 billion in fiscal 2013, according to the CBO. The extension of emergency unemployment benefits is also set to expire, which would further reduce federal spending obligations. Last, a reduction in Medicare payments to physicians would also lower federal outlays in 2013.

The Fiscal Cliff: Likelihood and Economic Impact June 20, 2012

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

Table 1
CBO Estim ates of Policy Changes Changes to Rev enue Policy Ex piration of "Bush Tax Cuts" Ex piration of "Pay roll Tax Cut" Tax es in the Affordable Care Act Other Ex piring Prov isions Changes to Spending Policy Budget Contol Act Sequestration Ex piration of Emergency Unemploy ment Benefits Reduction in Medicare Pay ments to Phy sicians
Source: Congressional Budget Office and Wells Fargo Securities, LLC

Billions, FY 2013 $221 $95 $1 8 $65 $65 $26 $1 1

Estimated Forecast Impact of the Fiscal Cliff

Estimated effects on the U.S. economy of the fiscal cliff have been well documented by the Congressional Budget Office and the Federal Reserve.4 Our view is consistent with these assessments in that barring some intervention on the part of Congress and the administration, existing law would result in a recession within the U.S. economy, beginning in mid-2013. We want to be clear that we are not currently forecasting this scenario. However, given the severe effect on the economy of a fully implemented fiscal cliff, we believe it is important to relay our forecast to our readers under the less likely case that Congress fails to address the upcoming changes to tax policy and federal spending under existing law. The net economic effects described below are our estimate of the shock to the U.S. economy under this worst-case scenario.5 Figure 3 Barring some intervention on the part of Congress and the administration, existing law would result in a recession within the U.S. economy, beginning in mid2013.

WF Economics Group Real GDP Forecast

3% Compound Annualized Growth Rate 3%

2%

2%

1%

1%

0%

0%

-1%

-1%

-2% WF June Baseline Forecast WF "Fiscal Cliff" Forecast -3% Q2 '12 Q3 '12 Q4 '12 Q1 '13 Q2 '13 Q3 '13 Q4 '13

-2%

-3%

Source: Wells Fargo Securities, LLC

4 Congressional Budget Office. Economic Effects of Reducing Fiscal Restraint that is Scheduled to Occur in 2013. May 2012. Bernanke, B. (June 7, 2012) Testimony to the Joint Economic Committee of the United States Congress. 5 The negative effects on GDP presented in this section have been computed in relation to our U.S. economic forecast published in our June 6, 2012, Monthly Economic Outlook.

The Fiscal Cliff: Likelihood and Economic Impact June 20, 2012

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

To understand the way in which the new laws would affect the economy, we go back to principles of macroeconomics. Economic growthmeasured by GDPis a function of consumer spending, business and residential investment, government purchases and net exports. As such, existing fiscal policy of tax increases and federal budget cuts of the magnitude described above will negatively affect the pace of growth. The increase in taxes would reduce disposable personal income, which in turn would reduce consumer spending. In addition, large cuts to federal government spending would directly reduce the total output in the economy and have the potential to spill over into state and local government spending as the federal government reduces its support to state and local governments. Individually, these policy changes would produce a moderate drag on economic growth, but their combined effects result in a contraction in GDP and slower growth path for the U.S. economy in subsequent quarters. The effects would likely be felt especially on two fronts, consumer spending and business investment. On the consumer side, spending would likely pull back as real disposable income declines due to the end of the Bush tax cuts and the payroll tax returning to its 2010 level. The increase to tax liabilities would be particularly detrimental to consumer spending in light of sub-2 percent real income growth, and would severely restrict the spending power of consumers across a wide range of the income spectrum. In particular, the middle class would bear the greatest burden due to the fact that they are still trying to recover their economic position prior to 2007 in light of lower asset values and weak wage growth. The second major effect on growth would come from a sharp pullback in business investment. The removal of accelerated depreciation on capital investments would produce a moderate drag; however, the drag to growth would also be reinforced as government orders contracted and consumer spending slowed. Furthermore, increasing taxes on capital gains and dividends would increase the cost of capital, thereby decreasing investment as the effective after-tax rate of return is lowered. With consumer spending weakened, businesses reducing investment and a decline in total output, employment would decline. Job losses would likely begin in the government sector and then gradually become more widespread, perpetuating the slowdown in domestic spending. The loss in defense jobs alone from the full-budget sequestration could reach as high as one million jobs.6 Depending on the depth of the resulting recession, job losses could be quite severe. We estimate that the combined effects of the tax increases and full-budget sequestration would likely result in a recession beginning in the third quarter of 2013 and continuing through the end of 2013. Our estimate is that negative growth in the first quarter along with a recession in the second half of the year would produce nearly flat growth for all of 2013. The resulting recession would likely significantly alter the long-term trajectory of the U.S. economy again, compounding the effects of the 2007 recession. Actual economic growth would fall even further from potential GDP, exacerbating the current output gap and weakening the labor markets recovery.

The resulting recession would likely significantly alter the long-term trajectory of the U.S. economy again, compounding the effects of the 2007 recession.

Fuller. S.S. (2011). The U.S. Economic Impact of Approved and Projected DOD Spending Reductions on Equipment in 2013. Center for Regional Analysis. George Mason University.

The Fiscal Cliff: Likelihood and Economic Impact June 20, 2012

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

Figure 4

Output Gap in the U.S.

Trillions of Dollars, Potential vs. Actual GDP, Inflation Adjusted $14.5 $14.0 $13.5 $13.0 $12.5 $12.0 $11.5 $11.0 $10.5 2000 Potential GDP: Q1 @ $14.3 Trillion Actual GDP: Q1 @ $13.5 Trillion 2002 2004 2006 2008 2010 $10.5 2012
Output Gap = $780 Billion

$14.5 $14.0 $13.5 $13.0 $12.5 $12.0 $11.5 $11.0

Source: U.S. Dept. of Commerce, Congressional Budget Office and Wells Fargo Securities, LLC

How Might Washington Avoid the Fiscal Cliff?

Separately, the changes to tax policy and expenditures would each exert a modest drag on GDP growth upon their implementation in 2013. Taken together, however, the impact would likely reduce GDP outright in the short run and send the United States into a recession. Using CBO estimates, the provisions outlined would reduce GDP by approximately 3.9 percent compared to the CBOs projected 2013 growth rate of 4.4 percent with no fiscal restraint, which implies a continuation of existing tax and spending policies. Despite the severity of the situation, it is unlikely that there will be any permanent resolution before the November election. Instead, policy makers will likely come to some sort of deal in late December to avoid falling off the fiscal cliff in 2013. What would this deal look like? A number of scenarios are possible. We have provided a rough probability for each of these options. The first, and what we believe would be most likely at this juncture, would be for a continuing resolution to be passed. This would keep current policies in place and push back the timing of the fiscal cliff for a few months. The new Congress, along with the president, would then be charged with determining a longer-term solution (60 percent). A second, and somewhat less likely, scenario would include a compromise between a change to both tax and spending policy prior to January 2013. In this case, some, but not all of the tax provisions that are set to expire would be extended, and some cuts to both defense spending and discretionary programs would also take place. However, the magnitude of these cuts would likely be reduced (30 percent). A third scenario would entail Congress doing nothing, and for the fiscal cliff to approach as scheduled. As we discussed in the previous section, this would result in a severe blow to economic growth in 2013. If this scenario occurs, there is one last option to avoid the fiscal cliff in January 2013. If the political dynamics of the new Congress change, Congress and the president could retro-actively roll back the tax increases set to go into effect. This would be done through invoking a provision of the Gramm-Rudman amendment, which requires any tax policy change to offset an

Separately, the changes to tax policy and expenditures would each exert a modest drag on GDP growth upon their implementation in 2013.

The Fiscal Cliff: Likelihood and Economic Impact June 20, 2012

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

equivalent amount of spending cuts.7 Given the degree of budget cuts that would be required, this is not an optimal solution for any party (10 percent). We believe the most likely scenario is that a short-term extensionsix months or less will be passed to essentially kick the can down the road.

The Most Likely Scenario

While there is still a large degree of uncertainty around what form tax policy changes will take in the year ahead, we believe the most likely scenario is that a short-term extensionsix months or lesswill be passed to essentially kick the can down the road to the administration and a new Congress. This extension, formally known as a continuing resolution, would likely include a continuation of the current tax cuts along with a reversal of the budget cuts agreed to last fall. We also expect a continuation of existing funding levels as part of a grand deal that would likely be struck sometime after the November elections. The effects on U.S. economic growth from political uncertainty were well documented during last years debt ceiling debate. As shown in Figure 5, consumer confidence fell last year in June and again in August as the fallout from the U.S. debt downgrade rattled consumers. In addition, business sentiment declined, as evidence from regional manufacturing surveys (Figure 6) pointed toward a slowdown in production activity as firms put orders on hold and slowed their purchasing decisions. We believe a similar effect is possible on both consumer and business confidence in the fourth quarter of this year if policymakers wrangle over how to continue the bulk of existing policies for a prolonged period. The short-term patch would then result in a second wave of reduced business and consumer confidence as the new Congress and potentially a new administration attempt to determine a more long-term solution to the currently unsustainable fiscal situation.8 Figure 5
Consumer Confidence Index
160 Conference Board 160 60 Philly Fed: May @ -5.8 (Left Axis) Dallas Fed: May @ -5.1 (Right Axis) Richmond Fed: May @ 4.0 (Right Axis) ISM: May @ 53.5 (Right Axis)

Figure 6
U.S. Manufacturing Indices
Diffusion Index 80

140

140

40

70

120

120 20 60

100

100 0 50

80

80 -20 40

60

60 -40 30

40 Confidence: May @ 64.9 20 87 89 91 93 95 97 99 01 03 05 07 09 11

40

20

-60 2007

20 2008 2009 2010 2011 2012

Source: The Conference Board, Institute for Supply Management, The Federal Reserve Banks of Dallas, Richmond, and Philadelphia and Wells Fargo Securities, LLC

The net effect of a short-term continuing resolution is that political uncertainty would be kept elevated through the end of 2012 and the first half of 2013. Due to this uncertainty, we expect the combined policy effects to keep U.S. economic growth positive, but for the pace of growth to be slower than it would be under a longer-term resolution. The impending uncertainty will weigh on growth leading up to a compromise in the fourth quarter of this year and produce an additional drag on growth toward the middle of next year as the debate reemerges. Under this extended scenario of political uncertainty, we expect economic growth to slow to 1.4 percent in the third quarter of this year and remain sluggish at 1.9 percent in the fourth quarter, consistent with our current economic outlook.9 The drag on growth will reappear again after the first of the year as
Gramm, Phil and Solon, Mike. The Budget Sequesters Silver Lining. Wall Street Journal, Nov. 18, 2011. 8 Congressional Budget Office. The 2012 Long-term Budget Outlook. June 2012. 9 For our complete U.S. Outlook see our Monthly Economic Outlook at http://www.wellsfargo.com/economics.
7

The Fiscal Cliff: Likelihood and Economic Impact June 20, 2012

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

Congress debates its next move, which is again reflected in our estimate for only a 1.7 percent annualized rate of GDP growth in the first half of 2013.

Conclusion: Downside Risks to Our Outlook Remain

The forward-looking nature of markets dictate that the effects of uncertain fiscal policy will begin to weigh on growth over the second half of this yearregardless of the outcome of the elections due to the extreme fiscal policy uncertainty. There are three possible scenarios that could transpire. First, there is a small chance that a more long-term solution could be reached involving some tax increases and reduced spending cuts for both defense and nondefense programs. Another possibility, which we believe is least likely, is that policy makers will fail to reach an agreement, sending the U.S. economy over the fiscal cliff. This worst case scenario, as we and others have estimated, would result in a 2013 recession. Our current view of the most likely scenario is that policymakers will come together after the elections and pass a continuation of existing tax policy and spending levels. This continuing resolution would essentially result in Congress and the administration kicking the can down the road until sometime early next year. This option would place a drag on economic growth and weigh on financial markets leading up to a deal likely sometime in December. Another headwind to growth would result in 2013 as political uncertainty increases again, while policymakers work to find a more long-term solution. Given this baseline scenario, we have incorporated this view into our June monthly economic outlook; however, downside risks remain to our forecast as the political uncertainty is already beginning to show some signs of dampening 2012 growth.

The forwardlooking nature of markets dictate that the effects of uncertain fiscal policy will begin to weigh on growth over the second half of this year regardless of the outcome of the elections.

H5h

Wells Fargo Securities, LLC Economics Group

Diane Schumaker-Krieg John E. Silvia, Ph.D. Mark Vitner Jay Bryson, Ph.D. Scott Anderson, Ph.D. Eugenio Aleman, Ph.D. Sam Bullard Anika Khan Azhar Iqbal Tim Quinlan Ed Kashmarek Michael A. Brown Joe Seydl Sarah Watt Kaylyn Swankoski

Global Head of Research (704) 715-8437 & Economics (212) 214-5070 Chief Economist Senior Economist Global Economist Senior Economist Senior Economist Senior Economist Senior Economist Econometrician Economist Economist Economist Economic Analyst Economic Analyst Economic Analyst (704) 374-7034 (704) 383-5635 (704) 383-3518 (612) 667-9281 (704) 715-0314 (704) 383-7372 (704) 715-0575 (704) 383-6805 (704) 374-4407 (612) 667-0479 (704) 715-0569 (704) 715-1488 (704) 374-7142 (704) 715-0526

diane.schumaker@wellsfargo.com john.silvia@wellsfargo.com mark.vitner@wellsfargo.com jay.bryson@wellsfargo.com scott.a.anderson@wellsfargo.com eugenio.j.aleman@wellsfargo.com sam.bullard@wellsfargo.com anika.khan@wellsfargo.com azhar.iqbal@wellsfargo.com tim.quinlan@wellsfargo.com ed.kashmarek@wellsfargo.com michael.a.brown@wellsfargo.com joseph.seydl@wellsfargo.com sarah.watt@wellsfargo.com kaylyn.swankoski@wellsfargo.com

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