Fiscal Cliff Notes

By Robert Bach, National Director, Market Analytics, Newmark Grubb Knight Frank: With the 2012 elections over, attention has turned to the looming “fiscal cliff,” the combination of tax hikes and spending cuts totaling approximately $718 billion in calendar year 2013 that threatens to tip the economy into recession.

 

With the 2012 elections over, attention has turned to the looming “fiscal cliff,” the combination of tax hikes and spending cuts totaling approximately $718 billion in calendar year 2013 that threatens to tip the economy into recession. The fiscal cliff consists of the following components:

 

Program

Impact on Budget in 2013 (in billions)

Expiration of Bush tax cuts

$210

No AMT patch

130

2% payroll tax break expires

110

R&D and other business credits expire

85

Spending cuts (sequestration)

109

Unemployment insurance extension expires

35

New Affordable Care Act taxes

25

Medicare doctor payment cuts

14

$718

The Congressional Budget Office (CBO) estimates that tax increases and spending cuts of this magnitude are likely to produce a decline of 0.3 percent in GDP for 2013 comprised of a moderate drop in the first half of the year – a recession – followed by a moderate recovery in the second half. The unemployment rate would rise from the current 7.9 percent back to 9.1 percent by the fourth quarter of 2013.

For commercial real estate, a recession, even a short and shallow one, would bring the predictable increase in vacancy rates and softening in rental rates. In the capital markets, investors would feel the increase in the capital gains tax rate from 15 percent to 20 percent plus a 3.8 percent add-on for the Affordable Care Act. Dividends, currently taxed at 15 percent, would be treated as ordinary income, and the top income tax bracket on ordinary income would increase from 35 percent to 39.6 percent. Additionally, private investors and high net-worth individuals would feel the increase in gift and estate taxes.

In exchange for a mild recession, the implementation of these policies would have a salutary effect on the nation’s budget, reducing the annual deficit from 7.3 percent of GDP in 2012 to 0.9 percent in 2022 and sending the debt-to-GDP ratio from 72.8 percent in 2012 to a manageable 58.5 percent in 2022.

Most analysts expect Congress to steer clear of the fiscal cliff, although legislators are likely to send the economy down a “fiscal slope.” Congress is likely to let the payroll tax break and the unemployment insurance extension expire on schedule, and taxes related to the Affordable Care Act will be implemented. Under the fiscal slope scenario, according to the CBO, GDP would expand by 1.7 percent in 2013 versus a 0.3 percent contraction under the fiscal cliff scenario. The unemployment rate would remain stable or decline slowly by the fourth quarter of next year, far better than the 9.1 percent forecast beneath the fiscal cliff.

For commercial real estate investors, the overarching concern seems to be with increased tax rates on capital gains, dividends, ordinary income and gifts and estates. Indeed the scheduled increases would dampen after-tax IRR by about ½ of a percentage point plus or minus depending on the amount of leverage in the deal. But the economy and its effect on tenant demand are likely to play a larger role than regulatory and tax policy in the health of the commercial real estate industry. Robust economic growth and demand for space will go a long way toward offsetting higher taxes and stricter regulations.