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Fiscal Cliff and Canada

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# Monday, December 10, 2012
Monday, December 10, 2012 3:40:41 PM (GMT Standard Time, UTC+00:00) ( Finance )
Talk is heating up about the looming financial situation in the United States commonly referred to as the "fiscal cliff". What exactly is this fiscal cliff, and what effect will it have on the Canadian economy?

What is the Fiscal Cliff?

There are a number of U.S. tax breaks and financial initiatives that will terminate at the end of 2012. These include:
  • Temporary payroll tax cuts for businesses.
  • 2001/2003/2010 tax cuts that were implemented by the Bush administration and continued by President Obama’s administration. This encompasses income tax (which will increase from 35% to 39.6%), capital gains taxes and estate taxes.
  • An alternative minimum tax (AMT) that will automatically apply to millions more Americans.
In addition the Affordable Care Act (e.g. "Obama" healthcare or "Obamacare") is scheduled to take effect in 2013, and will result in tax rate increases for high-income Americans.

Added to this mix are spending cuts (tied to the U.S. debt ceiling issue) such as:
  • No more extended Unemployment Benefits. This expires at the end of the year.
  • The Budget Control Act that involves spending cuts scheduled to go into effect January 2. Half of the cuts will come from national defense, with the other half from other non-defense sources.

How Might the Fiscal Cliff Effect Canada?

The first effect will be that time period when U.S. lawmakers attempt to deal with raising the U.S. debt ceiling. This results in market volatility, something that investors should be aware of. The most likely scenario is that a deal will be struck between Republicans and Democrats (likely at a late hour in the process).

How the U.S. deals with the impending tax increases, spending cuts and cessation of tax breaks will have a major impact on the U.S. economy. This issue is complicated: on one hand, the amount of U.S. debt is fast becoming a serious problem, and could result in a major devaluation of the U.S. dollar. On the other hand, more taxes along with spending cuts will remove a substantial amount of money out of the system, thereby stalling an already fragile economic recovery.

The Canadian Finance Minister Jim Flaherty stated right after the U.S. election that "Were the entire fiscal cliff risk to become reality, the effect on U.S. GDP, according to the Americans themselves, would be four to five per cent, which would put the U.S. economy into recession quite quickly and the Canadian would follow shortly thereafter". Ominous words from someone who should know!

76% of our Canadian exports are sent to the U.S., and bilateral trade between Canada and the United States is more than $1.7 billion a day. A shrinking U.S. economy will result in less trade, resulting in less money in Canada.

TD Bank economists estimate that the fiscal cliff could decrease Canada’s GDP by 1.2%-1.8%. Of particular note is that U.S. tax hikes impact Canadian exports more than American than spending cuts do.

Other factors to consider are:
  • The level of confidence of the U.S. consumer is directly related to Canadian exporters. The lower the confidence, the lower the exports.
  • Lower Canadian consumer confidence impacts negatively on the Canadian economy, especially during high retail sales periods such as Christmas.
  • A decrease in credit availability will increase the demand for Canadian investment. Bond prices will rise and fixed rate mortgages will stay low (along with low yields).

Conclusion

If all tax increases and spending cuts are implemented come the New Year, then the recovery of the U.S. economy is at risk. How much of an impact remains to be seen.

On the other hand, according to Congressional Budget Office the pending cuts and tax increases would decrease the 2013 U.S. federal deficit in half (to $641 billion). That is a major decrease, and the U. S. has to get a handle on their spending. A sky rocketing national debt is not sustainable in the long run.

There is no doubt that a significant slowdown in the U.S. economy will have a negative impact on the Canadian economy. Recovery of many countries all over the world is fragile at best, and while Canada is faring better than most, it is not immune to U.S. (and global) economic downturns.