Next Tuesday, the country will elect its President for the next four years. Exactly one week later, Congress will return to take up a critical piece of deferred business that could dramatically affect the country for the next four years and even beyond, regardless of who wins the Presidential election.
In a culmination of circumstances that collectively embody the current dysfunctional political climate in Washington, the country faces what has been called a “fiscal cliff.” Unless Congress is able to implement some remedial steps, after December 31 a host of temporary tax cuts will expire and a series of dramatic spending cuts will kick in. If Congress does not act, the changes could have a significant impact on the country’s economy. The impacts could also have serious negative implications for a wide variety of businesses and industries.
In this post, I first take a look at the details of the impending “fiscal cliff.” I then review the range of alterative paths that events might take and consider the possible implications for affected industries and companies. I conclude with an appraisal of the business risks these possibilities might present. As discussed below, the potential consequences could include, among other things, at least the possibility of a heightened litigation risk.
What is the “Fiscal Cliff”?
The phrase the “fiscal cliff” refers to a likely budget crisis and to a corresponding projected slowdown in the economy if specific laws are allowed to expire or to go into effect at the beginning of 2013. The changes include tax increases that will go into effect due to the expiration of the Tax Relief, Unemployment Reauthorization and Job Creation Act of 2010, which had among other things extended the Bush-era tax cuts. The expiration of the tax cuts would result in an increase in all income tax rates, as well as the rates on estate and capital gains taxes. In addition, the alternative minimum tax will revert to 2000 tax year levels; federal unemployment benefits will expire; and the 2% federal payroll tax reduction will terminate.
The changes also include the automatic spending cuts (“sequestrations”) mandated by the Budget Control Act of 2011, because the Congressional budget “supercommittee” created by the legislation failed to agree on a deficit reduction plan. Annual cuts of $109 billion per year will go into effect, with over half of the cuts coming from defense spending.
Just to complicate matters further, the federal government will likely hit its current debt level limit in early 2013, which could introduce yet another destabilizing budget issue that Congress must address at or about the same time.
As detailed in an October 9, 2012 post on the New York Times Economix Blog (here), if the changes go into effect, “almost everyone who pays taxes will see a hit to take-home pay in the first paycheck in January.” The White House estimates that a family of four with an income of $50,000 to $85,000 would pay an additional $2,200 in taxes during the 2013 tax year.
The spending cuts will also have an enormous impact. The Bipartisan Policy Center is predicting that the cuts alone could cost one million jobs in 2013 and 2014. The Congressional Budget Office predicts that economic growth would decline by 2.9 percent during 2013. There is a real risk that the country would experience a “double-dip” recession. I note parenthetically that most of the discussion about the possible effects if the U.S. goes over the fiscal cliff is focused exclusively on the consequences for the U.S. There undoubtedly will also be consequences for the global economy as well, at a time when a host of other economic factors already threaten to undermine the still-fragile recovery from the credit crisis.
To be sure, there is some reason to believe that while the increased taxes and budget cuts could have serious short-run negative effects, the longer run effects could produce not only significantly reduced deficits (as much as $7.1 trillion reduction in the national debt over the next ten years, versus a $10-11 trillion increase if current policies are extended for the next ten years), but also the reduced deficit and debt could lead to higher long-term growth prospects. Indeed, because of the significant long-term problems associated with the country’s current and growing debt level, if Congress merely extends current policies, growing interest costs will become an increasingly significant drag on the country’s economy.
There are those who believe that perhaps the country would be better off taking the “strong medicine” associated with the tax increases and across the board spending cuts (more about which below). However, automatic spending cuts, no matter how effective as a way to reduce the deficit, do not necessarily represent good policy, or really policy of any kind. To cite but one example, even if cuts to defense spending are a good idea, cuts affecting our military capabilities should only occur in a careful and considered way, not simply by lopping off a huge slice of the defense budget. As serious as are the problems associated with the deficit, defense budget cuts can’t be administered without knowing whether or not they could compromise national security.
On an even more immediate level, if Americans were to see their take home pay slashed dramatically simply due to Congress’s failure to act, there would be a political firestorm of epic proportions. The political backlash could be even further intensified if Congressional inaction results in economic constriction and massive job losses.
The Congressional Alternatives
There is enormous pressure for Congress to act. Indeed, the conventional view is that the consequences of inaction are so severe that Congress will almost certainly do something, even if it is just to kick the can down the road for a few more months. The problem for the country and for Congress is that the picture is scrambled. The current budget issue will soon become an economic and financial problem but at the present moment, at least for the members of Congress who will have to address the issue, the situation represents a political problem. It is not just the uncertainty due to a Presidential election that remains extremely close. Many Congressional and Senate races also are also close, and the outcomes of a number of individual races could have an impact. Margins of victory and shifting majorities could also come into play. The Congressional body that will have to address these issues before year end will be composed of an as yet indeterminate number of lame duck politicians whose motivations and interests could be effected by next week’s elections. Add to this volatile political mix the possibility of a lame duck President, as well.
There are a variety of other factors that could further complicate Congressional efforts to confront these issues. Perhaps the most significant is the scarcity of working days between November 13 and year end. There is not much time for Congress to grapple with issues that are both complicated and controversial. In addition, notwithstanding the serious threat that the looming budget crisis presents, there will inevitably be a certain number of Congressmen who, with an eye to the 2014 elections, are willing to provoke a crisis in order to be able to try to pin the blame on the other party.
In addition, there are serious commentators and observers who believe that the best thing for the county would be for the automatic tax increases and budget cuts to go into effect. As discussed in an October 26, 2012 Washington Post article (here), those who subscribe to this view (who are known as “cliff divers”) believe that only the exigencies of the crisis will put enough pressure on Congress to reach a “grand bargain” that represents a comprehensive and considered approach to the country’s deficit and debt problems. These commentators also believe that if Congress rushes to act in the little time remaining, a short-term sub-par deal could result, that, once in place, would make it harder for Congress to find the will to grapple with the fundamental issues.
One additional consideration that must be taken into account in assessing whether or not Congress will act is the obvious fact that merely because the country faces a looming economic crisis does not mean that Congress will find a way to do something. The reason the country is approaching the fiscal cliff in the first place is because of the adversarial parties’ past failures to work together and the willingness on the part of some to engage in political brinksmanship. The forces that have produced past stalemates could take the country right off the cliff. All it takes for the country to go off the fiscal cliff is a little bit of political gridlock — which happens to be the specialty of this particular Congress.
What This Means for Business
There are a host of problems that could arise quickly in the new year if Congress does not act before year end. But the looming crisis is already having an impact. As detailed in an October 25, 2012 Washington Post article entitled “Fiscal Cliff Already Hampering U.S. Economy” (here), companies “are bracing for the fallout by laying off workers, letting jobs go vacant and postponing major purchases.” According to the article, Department of Commerce data show that business investment stalled in September. Some companies have already begun laying off workers as a cost-containment effort in anticipation of further downturn next year.
These problems will quickly accelerate if Congress fails to act to avert the tax increases and spending cuts. Among other things, the impact will quickly be felt in the defense industry, where the sequestrations could quickly result in layoffs. The budge cuts could also have a significant impact on the many small businesses that depend on government contracts. The potential problems for many other industries may be more difficult to discern now, but the impacts could be diverse and wide-spread. For example, there are predictions that there could be significant adverse impacts on the commercial real estate sector as vacancy rates climb. Manufacturing, which only recently has begun to rebound from the ill effects of the credit crisis, could also be affected. A sharp increase in taxes would likely produce a sharp downturn in consumer spending, particularly for discretionary and luxury products. Even the purchase of consumer staples (such as appliances and furnishings) could face a sharp decline.
At a minimum, businesses face a climate of uncertainty. With uncertainty, comes risk. In light of this uncertainty and risk, some advisors are cautioning companies to be sure to incorporate precautionary disclosure in the public statements as a way to forewarn investors about the potentially harmful impacts that could arise if Congress fails to act.
For example, in their October 23, 2012 memorandum entitled “The ‘Fiscal Cliff’: Look Before You Leap Into the Securities Litigation Trap” (here) the Choate, Hall & Stewart law firm advises companies to “assess their exposure to the fiscal cliff” and if the risks are sufficient to “factor the relevant trends and uncertainties” into the earnings guidance, as well as into their public filings and statements to investors, particularly during the current quarterly reporting season.
It is worth emphasizing the reasons the law firm is advising that companies take these steps; the memo notes that in light of the potential consequences for companies from the budget crisis, the companies can be sure that the plaintiffs’ lawyers “will be on the lookout for targets of ‘stock drop’ securities fraud class action litigation.” Companies that suffer adverse impacts from the looming crisis could face allegations that resulting stock price declines are the result of a company’s misrepresentations with respect to, or failure to adequately disclose, these risks. The memo observes that “a company that warns with sufficient detail that its forecasts are subject to uncertainty because of the fiscal cliff events may both discourage litigation before it starts and have a better chance of prevailing should it be targeted nonetheless.”
Congress and the county are approaching a dangerous crossroad. Though Congress can defer the day of reckoning temporarily by (again) kicking the can down the road, the ultimate showdown can only be postponed, and only then for a short time. Sooner or later Congress will have to confront the problems associated with the growing cumulative deficit and enormous debt. The country’s best interests would be served if Congress were to be able to reach the so-called “grand bargain” that addresses both revenue and spending concerns and puts the country on a long-term path towards meaningful debt reduction. Whether a sharply divided Congress (representing a sharply divided electorate) can reach this type of agreement could prove to be a very tough proposition.
In the meantime, both households and businesses face an environment of uncertainty and attendant risk. Businesses already face difficult choices about what steps to take in order to be prepared for the possibility that Congress might fail to act. The risks companies face take a number of forms, but among the risks is the increased litigation exposure that can arise when companies’ fortunes take a sudden negative turn. As we saw during the credit crisis, adverse economic circumstances can beget a huge increase in litigation. In light of these risks, companies would be well advised to follow the recommended course of precautionary disclosure outlined in the law firm memo linked above.
D&O underwriters also face a difficult task in this environment. The question whether or not to adjust underwriting and risk selection in the current atmosphere will be challenging, as it unclear whether or not there really be any kind of crisis that could produce adverse claims events. It is will be equally challenging to try to anticipate which companies – or even which kinds of companies — will be most adversely affected if there really is a crisis. As if that were not enough, events will be moving fast over the next few weeks, much faster than the usual efforts to adjust underwriting practices and policies require.
Among the questions the D&O underwriters will have to consider is whether or not to begin taking a more cautious approach to the industries that will most obviously be affected if Congress fails to act, and if so, which industries to target. The underwriters will also have to consider how to scrutinize company disclosures in order to determine whether or not a particular company has been sufficiently precautionary. And the D&O underwriters will also have to adjust their positions as events unfold.
It will be interesting to see the outcome of next week’s election. I have to say, as an Ohio resident, this election can’t end soon enough. The around-the- clock political ad bombardment to which Ohio has been subjected is more than anyone should have to bear. But while it will be great to finally come to the end of this year’s electoral season and it will be interesting to see how the voting unfolds, there will be little break after the election is over. Regardless of who wins, there will be some serious issues for this country’s political leaders to face, right away.
In closing, I want to quote Minneapolis Star-Tribune Columnist D.J. Tice (here): “The smart way to resolve the debt crisis” will require a little more from Americans and their representatives. It will “require that Americans broadly stop telling themselves that only somebody else is responsible for the country’s budget mess, that only somebody else needs to pay higher taxes, and that only programs somebody else values need to be cut. It would require that politicians start telling the truth, and that voters reward them for it.” Tice’s position is absolutely correct. Unfortunately, he may also have identified the precise reasons why the crisis may not be averted.
Cliff Notes: Perhaps because of the vivid imagery involved in the characterization of the looming budget crisis as a “fiscal cliff,” the prospect of the country plunging off the budgetary precipice has inspired a number of cinematic allusions. The most evocative is the reference to the cliff divers’ approach as representing a prescription with a certain “Thelma and Louise” quality – desperate and doomed.
If Congress were to fail to act and the country were to race off the fiscal cliff, I think the experience for many Americans will be much like that of Wiley Coyote, shortly after chasing the Roadrunner off of a cliff – like the cartoon character, our legs will pump empty space briefly, and then, after a sudden and startling recognition that we are hanging in mid-air, we will plunge into the abyss.
And a Congressional debate in which some voices will contend that the best course for the country is to hurtle off the cliff will resemble the quarrel that Butch Cassidy and the Sundance Kid had as they argued about whether to try to escape their pursuers by jumping off a cliff into a raging torrent below:
Butch Cassidy (played by Paul Newman): Alright. I’ll jump first.
Sundance Kid (played by Robert Redford): No.
Butch Cassidy: Then you jump first.
Sundance Kid: No, I said.
Butch Cassidy: What’s the matter with you?
Sundance Kid: I can’t swim.
Butch Cassidy: Are you crazy? The fall will probably kill you.
For those who don’t remember the movie, the two do jump off the cliff and they manage to survive the fall. However, they don’t escape their pursuers and they ultimately are taken down in an epic gun battle.