Looming 'fiscal cliff' is hurting US economy now, economists warn

Look out below. Despite some positive signals from the US economy lately, a scheduled increase in taxes next year may pose an immediate risk of slowing growth.

The challenge is this: When businesses see a high level of uncertainty about the policy climate – in this case whether taxes will go up or not – they may operate in a wait-and-see mode that holds back their hiring and investing decisions.

Some economists say that's exactly what is already happening – and that it's likely to damage the economy in coming months, as the nation awaits action from Congress.

This view runs counter to the media chatter in the current political campaign. Many pundits talk about the "fiscal cliff," which includes the expiration of tax cuts on Dec. 31, as if the potential for economic harm would begin on that date. And they expect that Congress and the president will do something to soften the blow through legislation after the November election, because otherwise the negative shock of tax hikes plus billions in scheduled spending cuts could tip the US back into recession.

The problem is, there's no telling exactly what will happen or when, given Congress's current gridlock and the wide divergence in tax proposals between President Obama and his rival, Mitt Romney.

"Those two candidates are miles apart," says Steven Davis, a University of Chicago economist. "I cannot think of another time in recent decades when there appeared to be that much uncertainty about the tax treatment of business income riding on an election."

The uncertainty surrounding the fiscal cliff and other looming tax decisions, he says, is having an impact on businesses today.

It's showing up in surveys of businesses, including in the informal "beige book" interviews conducted by the Federal Reserve, Mr. Davis says. He also cites recent research, which he conducted with economists Scott Baker and Nicholas Bloom of Stanford University, on the link between policy uncertainty and economic growth. The researchers drew on several data sources to create an index of uncertainty, and found that a spike in such doubt often foreshadows weakness in the economy.

"When policy uncertainty levels are high, that does not bode well for future economic performance," Davis says. In his view, a new recession is possible, with risk coming from events in Europe as well as the US.

The fiscal cliff, by some estimates, could suck about 5 percentage points out of gross domestic product in 2013, if various tax cuts expire as scheduled, alongside some spending cuts.

Many forecasters share Davis's concern, at least to some degree. 

Economists at the investment bank Morgan Stanley recently downgraded their outlook for US gross domestic product (GDP) in the second half of this year, citing "headwinds" from turmoil in Europe and the fiscal-policy doubts at home.

Looking further ahead, the team at Morgan Stanley expects that, ultimately, Congress and Mr. Obama will agree to a deal during the "lame duck" session of Congress, after the election. Essentially, the Bush-era tax cuts would be extended and spending cuts delayed, but the phaseout of some tax breaks would still total about 1.5 percent of GDP. That would exert some slowing influence next year – but not be bad enough to cause a recession.

Some forecasters are more pessimistic.

Economist Peter Morici of the University of Maryland wrote in a recent commentary that if Obama and Congress continue to delay dealing with the fiscal cliff, the economy could suffer sharply.

"Businesses are already curtailing investments in machinery and information technology as a hedge against a contracting economy in 2013, and consumers are spending less," he writes.

Mr. Morici says a new recession is possible, even if policymakers act during the lame-duck session to reduce the size of the cliff. It might be too little, too late. And since the Fed and Congress have already spent big in the past few years to try to ignite a recovery, getting out of a new recession would be very difficult, he argues.

The latest news on the economy has some bright spots. Retail sales edged up in the most recent month, after three months of decline. And on Friday, Reuters and the University of Michigan reported that a monthly gauge of consumer sentiment rose.

The Dow Jones Industrial Average has bounced back above 13000 in recent days.

But that doesn't remove the fiscal cliff and other election-related concerns.

Some 9 in 10 small businesses are concerned about Congress’s ability to reach consensus on expiring tax rates and other elements of the fiscal cliff, according to a recent Harris Interactive poll, sponsored by the US Chamber of Commerce.

More generally, 62 percent of likely voters in an American Pulse poll said the uncertainty of the election is affecting their spending habits.

Amid the climate of concern, many economists say it would be best if Congress and the president could act sooner rather than later – or risk seeing the economy deteriorate on their watch.

Davis says he'd like to see a six- or 12-month deal to extend the Bush-era tax cuts and to postpone spending cuts. Similarly, while acknowledging the difficult partisan politics, Morici calls on both sides to compromise now.