America battles to pull back from the precipice

Nikhil Kumar assesses where the pain will be felt if US economic woes trigger automatic tax hikes totalling £274bn

Big business is taking no chances as the White House and Congressional Republicans attempt to hammer out an agreement to stave off more than $600bn (£374bn) in automatic tax hikes and spending cuts beginning of 2013.

As the politicians work out a deal, the possibility that tax rates on dividends could climb in the new year has triggered led boards across the land to declare special or early payouts, allowing investors to bank incomes before the Bush-era dividend levy of 15 per cent expires. That figure could climb to around 40 per cent if the country goes off the cliff, prompting companies such as Wal-Mart to bring forward their payout schedule. The retail giant moved it dividend date from 2 January to 27 December, ensuring that its shareholders – principally the Walton family, which owns around half the stock – have a happy Christmas.

But dividends are just one part of the story. Nearly everyone will face higher taxes if no compromise is reached in time. Payroll taxes, for example, are due to rise by 2 per cent to 6.2 per cent as temporary breaks expire.

All told, the cliff equates to a readjustment of more than 4 per cent of US GDP, a potential body blow to an economy already struggling to get back on its feet.

"Going over the cliff risks economic instability and would send the US, even the world, into recession," Deutsche Bank bank analysts said in a note to clients last week. Angel Gurria, the secretary general of the OECD, sounded a similar warning as the body released its economic outlook.

The red flags were the latest in a series. Earlier in November, the independent Congressional Budget Office ran the numbers on what might happen if the politicians fail to reach a compromise. It predicted that it would drive up US unemployment to more than 9 per cent by 2013, against the less than 8 per cent seen in October. The economy, meanwhile, is likely go the other way, nose-diving into another recession.

The White House, while avoiding the 'R' word, also weighed in with some numbers recently, warning that the automatic federal tax hikes could prompt shoppers to tighten their purse strings this holiday season as they worry about political deadlock.

"The typical middle-class family will see their taxes go up by $2,200 next year, negatively impacting businesses and retailers across the nation," a report from the President's Council of Economic Advisers warned. The report predicted that American consumers, faced with a steeper tax bill, could reduce their spending by $200bn next year. If anyone was left in doubt about the potential impact of such a shift, the White House offered a subtle reminder in the form of a note clarifying that consumer spending made up roughly two thirds of the American economy.

The high stakes suggest that, in the end, some kind of deal will be forthcoming – even if it hits investors with a higher levy on dividends. "The fiscal cliff, we'll get through it because we know what Congress is going to do," John Brynjolfsson, chief investment officer at the Armored Wolf hedge fund said on the sidelines of the a recent Reuters investment summit in New York. "They've done it every time for the past 40 years, which has been to spend more, tax less, have bigger deficits – and they're going to pat each other on the back and say 'we've done great'."

Former Republican Congressman Bill Frenzel was equally certain that a pact will be reached. "Falling – or jumping – off the cliff is good policy, but only if you like recessions, enjoy unemployment, and don't mind living in the ashes. The economists who tell us the fall means a recession are not fooling," he said in a recent op-ed published by the Washington DC-based Brookings Institution. "The cliff is real... Responsible politicians will avoid it at all costs."

One scenario, outlined by Deutsche Bank, anticipates a deal that would reduce the cliff to around $180bn – or 1 per cent to 1.5 per cent of GDP. Alongside, Deutsche analysts expected the federal debt ceiling to be lifted, either as part of the fiscal cliff deal, or soon thereafter. This would still call for further negotiations over the course of next year to bring down the deficit.

But given the distance between the avowed preferences of the White House (which wants higher taxes on the wealthy and extension of relief for those earning under $250,000) on the one hand and House Republicans (who on Monday reiterated their opposition to raising rates for the rich, preferring instead to raise revenues by wiping out deductions) on the other, expect much wrangling between now and late December, when some kind of deal is expected. And this in itself presents risks, as it causes uncertainty and dampens market sentiment.

American factories have already begun adopting a defensive posture, with activity shrinking instead of growing as managers worry about the cliff. The result: manufacturing contracted in November for the first time in three months, according to a gauge published by the Institute for Supply Management.

The worries, as Democrats and Republicans engage in a PR battle to push their agendas, even prompted the Chinese to weigh in.

"American politicians should understand that a 'self-created' recession will gravely erode both the soft and hard power of the United States," the People's Daily, regarded as a mouthpiece of the ruling Communist Party, said as another round of meetings in Washington appeared to have done nothing to bridge the gap between the two sides.

"A country such as the US that is accustomed to telling other nations to be responsible, should... show itself to be a responsible power."