The fiscal cliff which is right in front of us will arrive on January 1st, 2013. The most important change will be the expiration of the Bush tax cuts. Each citizen of the U.S. will have a tax hike starting next year. The result will be a decline in savings rate. Tax rates can be said to affect the savings inversely both in the personal and corporate levels. It means that in the cases when the tax rate increases, the rate of savings may fall while with a decrease in the tax rate, the savings may increase.
Overall, the personal income tax rate will go up 3% with the exception of the lowest and highest income earners who will have a whopping 5% tax increase. This tax increase will therefore reduce the disposable income of each and every person and business in the U.S.
So what does this mean in simple numbers? If I earn 3000 dollars and I am taxed 33%, I will have 2000 dollars of disposable income. If I save only 3% of my disposable income (see chart 1) I am saving 60 dollars. If now the taxes on my personal income go up 3%, I will need to hand over 90 dollars to the government. My disposable income will be 1,910 dollars. This means I'm going underwater: 60-90 = -30.
There are only two ways to prevent me from getting underwater (due to tax increases) and that is either have rising wages or cutting consumer spending.
Let's look at the first option: rising wages.
We already know that employment is declining even though the unemployment rate is steady at 8%. That's because more and more people are taking part-time jobs and this is evident from chart 2. The average weekly hours worked has steadily declined.
As a result, real median household income has declined with it and I don't see any improvement in the future due to the difficult economic conditions today (Chart 3). So this first option is not viable.
The only way to prevent savings going under zero is the second option: to cut consumer spending. Once consumer spending falls, we will certainly enter another period of recession. We will have zero GDP growth and maybe even have negative growth for a while. It is estimated that we could have a contraction of as high as 3% in GDP. As for businesses, the decrease in savings will have an effect on investment. With less savings, businesses will have less money to invest in growth (Chart 4). Less factories will be built, the real estate market will drop. This will weaken the jobs market considerably. We noted recently that the U.S. federal reserve is even anticipating a scenario of 12% unemployment, asking banks to test on a "deep recession" scenario.
While nearing the end of 2012, there is a big uncertainty about the fiscal cliff (and the debt ceiling). If the current discussion on the fiscal cliff results in an automatic increase in the taxation of the consumer and the businesses, we will have certainty on a coming recession/depression as the low savings rate and low real wages don't support the increase in taxation. Consumer spending and business investment will drop and clearly, the stock market could drop another 20%.
I advise investors to at least wait till the end of 2012 to get into the stock market (NYSEARCA:SPY). The reasoning behind this is that markets will be volatile due to the uncertainty concerning the fiscal cliff. Moreover, the U.S. stock market has outperformed almost every other stock market in the world and therefore I believe the U.S. stock market is overcrowded for the time being.
What investors can do instead is to consider other asset classes like cash (NYSEARCA:UUP) and precious metals (NYSEARCA:GLD), (NYSEARCA:SLV) in the short term. Being in these safe havens could provide liquidity in an event of a further correction in the stock market in the coming months.
Disclosure: I am long PSLV, PHYS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.