Fiscal

Cliff Contingencies
Micro Economic Analysis of the Anticipatory Effects of Probable Tax Increases and Spending Cuts Activated in 2013

December 2012
Nicholas Bucheleres (nick.bucheleres@gmail.com) Shane Freeman (shanius13@gmail.com) Carol Liu (liuchuq@umich.edu) Under the guidance of Professor Stephen Salant (ssalant@umich.edu) The University of Michigan Department of Economics

Abstract While debate over the Fiscal Cliff mostly centers around its latent whiplash effects on the United States economy, its inception is wholly a product of poor deal- making by politicians in Washington D.C. The series of agreements that led to what we know as the Fiscal Cliff began in 2010 in a divided Lame Duck session, where Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, thereby extending the Bush Era tax-cuts for an extra two years. Affected by these tax-cuts were individual, corporate, estate, and trust taxes, as well as Social Security employee payroll taxes. Other than foregone tax revenues, the bill passed by lame duck Congress

presented no unprecedented negative externalities. The fuse in the current fiscal bomb would not be lit until the summer of 2011 when the US began to bump up against its legal debt ceiling once again. On August 2, 2011, at the hands of the same politicians that hastily extended tax-cuts just a year earlier, Congress passed the Budget Control Act of 2011.1 The Act created a Joint Select Committee on Deficit Reduction whose impetus revolved around crafting a plan by November 2011 that would reduce the then $15+trillion in federal debt by $1.2trillion over 10 years. If an agreement was not met by November 2011, the Budget Control Act of 2011 mandated that a series of federal and defense spending cuts (sequestration), and middle-class tax hikes (enacted by the 2010 Affordable Care Act) would kick in. 1 Had the debt ceiling not been raised, the US Treasury would not have legally been allowed to expand its balance-sheet in order to service existing debt. Following a credit event, the US would default on its debt, and thereby forfeit the status of the US Dollar as the international reserve currency. 2

Starting April 2011, ratings agencies began issuing official statements warning of a possible US credit downgrade if Congress failed to reach a deal over the federal debt. Of course, Congress did in fact fail to reach an agreement on a bi- partisan debt reduction pact, which prompted the debt ceiling to be raised. Days after Congress passed the Budget Control Act raising the debt ceiling for the 47th time since 1917, Standard & Poors downgraded the US federal government credit rating from AAA to AA+, marking the first time in history that US debt was rated below AAA. The impact of the one-time downgrade in the creditworthiness of US debt

was minor, but it stands as an omen for what will befall the US in the event that the Fiscal Cliff is not resolved smoothly. Recent history with the federal debt/deficit underlines why the current Fiscal Cliff debate is so contentious, and the implications of a failure to responsibly address the issues of the Fiscal Cliffboth in the short- run and in the long-runare the motivation for our exploration into the drag that such a political failure would have (and is currently having) on the US economy as analyzed through our model of Fiscal Cliff contingencies for various agents. Introduction Our modeling of Fiscal Cliff contingencies facing the United States focuses on

consumers and producers living and/or transacting in the United States. Our treatment will begin with households engaging in non-financial consumption decisions, specifically while facing a probable tax increase. We incorporate the consumers expectations by utilizing a probability coefficient consistent with the

prevailing consensus probability that the Fiscal Cliff is averted by December 31, 2012.

Next we look at how potential spending cuts would hurt US manufacturers, specifically in the defense industry. The defense industry faces a potential demand shock on January 2, 2013; this type of shock affects capital expenditure, investment, employment, as well as related aspects of business capital allocation. Finally, we analyze the magnitude of the anticipatory effects of these tax

hikes and spending cuts on the real economy. There has been a marked divergence within the real economy throughout most of 2012 between producers and consumers. We use our model to investigate why this is the case. Effects of a Probabilistic Tax Increase In our model, we examine how the consumers awareness and anticipation of the potential fiscal cliff will affect her consumption choices. It is already clear that

one of the major impacts the Fiscal Cliff will have on a consumers daily life is a substantial tax increase. Although the exact date of the tax increase is still uncertain, for simplicitys sake, we only look at two points on the timeline: one is t0, which we regard as today, and the other one is t1, the time when the tax increases will actually go into effect. We assume an endowment economy with a single consumption good. At t0, each consumer gets an identical one-good consumption bundle from an outside person. As a rational being, one chooses to allocate her endowment across the two time points in order to maximize her total utility. For example, one may choose to take part of her consumption out at t0, and save it for t1 if she thinks that she will have less adequate wealth at t1. At t1 there are two states: Fiscal Cliff and No Fiscal Cliff. Each consumer has her own probability for which she anticipates the Fiscal Cliff will happen at t1. We call this probability . It is obvious that the probability that the consumer expects the Fiscal Cliff not to happen is 1-. A clearer representation of the paradigm at t1 is demonstrated as below: a Event Fiscal Cliff Probability Maximum Consumption 1- C1 C1

b No Fiscal Cliff

Remember that the maximum level of consumption one can consume at the second period is determined by the decision she made at t0; that is, in order to maximize utility across two points in time, she must decide how much she should consume at t1. We denote the consumers consumption at t0 by C0 and her consumption at t1 by C1. Therefore, at t1 the maximum amount of consumption possibilities at each state for the consumer is simply C1. The probability that the Fiscal Cliff tax increases take effect are determined by consensus probabilities on InTrade, so consumer has a chance to maximize her expected utility by trading her consumption possibilities at a certain price ratio and consuming different amounts at each state (more on this later). We denote her consumption in state a by Ca and her consumption in state b by Cb. If there is no mechanism such as Intrade, the consumer will have no way to allocate her wealth across the two uncertainties and therefore her consumptions at two states are restricted to be the same. In this case Ca and Cb both equal C1. We will see whether the consumers anticipations will have an effect on her consumption choice, especially C0. In other words, we will examine whether there is a relationship between C0 and . We first look at the consumers budget constraint line across two time points. Suppose we have identical consumers. Each consumer receives an endowment bundle at t0. We denote it by E= ( y0E, y1E). This point is marked as E in the graph. However, the consumer can choose to consume at a different point on the budget constraint line through borrowing or saving.

C_1

C_1

C*

y(E)_1

C_0

y(E)_0
C_0

Suppose savings are intermediated through banks. Thus the consumer earns interest in the portion of wealth that she chooses to save. We assume constant market interest rates for both lending and borrowing, denoted by i. The amount of wealth that the consumer chooses to save for t1 plus the interest generated by the saving becomes the extra consumption possibility she gets at t1. Then a budget constraint across time could be set up:
! savings 1 + i = C! y! ! ! y! C! 1 + i = C! y! ! ! Rearrange: y! 1 + i + C! (1 + i) = C! y!

! ! C! = y! 1 + i + y! 1 + i C!

This is the budget constraint equation that the consumer is subject to while optimizing across times. It is a straight line with the slope of (1+i), with we have C1
! ! on the y-axis and C0 on the x-axis. (Note that the intercept on the x-axis y! + y! /(1 +

i) is simply the present value of the endowment.) We set the endowment given for each state to be E, the total wealth of when the Fiscal Cliff happens to be X, and the total wealth when it does not happen to be Y. The total wealth at each of the two states becomes: Y = E p x X = E + 10 p x This can be solved by canceling out x: Y=E We can see that there is a linear relationship between the total wealth in state a and in state b. The takeaway is that the consumption in states a and state b can be traded at a price ratio so that the expected utility of the consumer can be maximized. For example, the consumer can choose to consume more if she thinks that the Fiscal Cliff is very likely to happen and vice-versa. Suppose the price of XE p 10 p

consumption in state a is Pa and the price of consumption in state b is Pb. Therefore a budget constraint across the two uncertainties can be set up: P! C! + P! C! = P! C! + P! C!

C_b

U
C_b

45 0

C_a
C_a

The budget constraint line is a straight line with a slope of (Pa/pb) when we put Ca on the x-axis and Cb on the y-axis. It is well-known that if t1 is the only time variable here (in order to maximize utility) a risk-averse consumer will always choose to consume at the point where the indifference curve is tangent to the

budget constraint line. Notice that if there is no InTrade probability, both amounts of consumption are restricted to be the endowment initially allocated to t1, which is C! . That is to say, C! = C! = C! . Now we have the two constraints that restrict the consumer while she maximizes her utility. We view the total utility as the simple addition of her utility at t0 and her expected utility at t1. The effect of a tax increase when the Fiscal Cliff happens is reflected by a (1 ) discounting of Ca: Total Utility = U C! + U C! 1 This is the function that the consumer is trying to optimize. Notice that we have three variables here in the utility equation: C0, Ca and Cb. Unlike when we simply optimize over time or uncertainty, the problem now becomes a three- dimensional maximization problem: the budget constraint is now a plane. The optimal point occurs at the point where the indifference curve is tangent to the budget plane. At first, we tried to solve the system of equations by taking C1 as given and solving the maximization at t1. Then (if possible) plug the optimal point we get at t1 back into the equation at t0 and solve for the concrete values C0, Ca and Cb. However, we realize that this is very unlikely to succeed because of information loss when combining equations. As a result, we decided to solve the problem by setting up simultaneous equations. Therefore our problem becomes: + 1 U(C! )

10

 max(Total Utility) = U C! + U C! 1 subject to:

+ 1 U(C! )

! ! C! = y! 1 + i + y! 1 + i C!

P! C! + P! C! = P! C! + P! C! We have three variables and two constraints. This can be solved using the Lagrange Multiplier Method. It is also worth noting that the endowment can also be regarded as the income of each consumer. That is, each consumer earns wage w at each time point. She chooses to save a part of her endowment s at t0 for t1 where she earns interest. The total wealth at t1 can be written as (w + s 1 + i ) when there is no Fiscal Cliff and w + s 1 + i 1 when the Fiscal Cliff exists. The budget constraints

can also be set up accordingly. However, the difference in the analytic results would be minor and therefore we will not go through the analysis. We combine the two constraint equations so that C1 cancels out:
! ! (y! 1 + i + y! 1 + i C! ) P! + P! = P! C! + P! C!

P! P! ! ! C! + C! + 1 + i C! y! 1 + i y! = 0 P! + P! P! + P!

11

This is the equation of the budget constraint plane. Here C0, Ca and Cb are variables. All other expressions can be treated as constants. We set up the Lagrange Multiplier System: dV + 1 + i = 0 dC! dV P! 1 + = 0 dC! 1 P! + P! dV P! 1 + = 0 dC! P! + P! and the constraint However, we notice that it is impossible to get a closed form of optimal C0 without specifying a utility function. Therefore, for simplicity we will assume that the utility function of the consumer is a function of a single variable and it possesses the properties of a Cobb-Douglas preference. First, we consider the utility function of the following form: V x = log (x) Then we can solve the Lagrange Multiplier Equations: P! P! ! ! C! + C! + 1 + i C! y! 1 + i y! = 0 P! + P! P! + P!

12

f x = log C! + log C! 1

+ 1 log C! + [

P! P! C! + P! + P! P! + P!

! ! C! + 1 + i C! y! 1 + i y! = 0

Solve forC! , C! , C! in terms of : 1 + 1 + i = 0 C! 1 P! = C! 1 (P! + P! ) 1 1 P! = C! (P! + P! ) 1 We have: C! = C! = C! = Plug back to the constraint and solve for : = 2 ! ! y! 1 + i + y! 1 (1 + i)

P! + P! P!

1 P! + P! P!

13

 Plug back to C! , C! , C! :
! ! y! y! C! = + 2 2(1 + i) ! ! P! + P! (y! 1 + i + y! ) 2P!

C! =

! ! (1 ) P! + P! (y! 1 + i + y! ) C! = 2P!

Thus we get the closed form of the optimal consumption points for a consumer with a utility function of log(x). It is very interesting to notice that the optimal consumption at t0 does not have the uncertainty factor involved. We can interpret the C! we found as half of the present value of the initial endowment. In other words, for a consumer with a natural log utility function, no matter how probable she thinks the Fiscal Cliff is, the utility-maximizing strategy at t0 is simply to consume half of the present value of the initial endowment and leave the rest half to the next time period. This is a surprising result, because a consumer with this kind of utility function, theoretically speaking, her consumption choice at t0 does not depend on the probability that taxes go up. As long as the consumer is aware that there may possibly be a tax increase in the future, a utility-maximizing strategy will be determined.

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When there is no Intrade, since C! = C! = C! , by simply plugging the time constraint equation into the total utility function, we get the following:
! ! Total Utility = log C! + log y! 1 + i + y! 1 + i C! + log (1 )

Clearly, a maximum can also be achieved by choosing appropriate value of C! . However, we verified through computer analysis that the optimal C! is also independent of . We consider another utility function: V x = x ! We solve the Lagrange Multiplier equations using the same technique as in the last example and arrive at the following optimal consumption points: (For simplicity, the redundant calculation steps will not be presented, nor will the result of C! and C! due to complexity.) Set
! ! y! 1 + i + y! F !

P! + P! 1 1 + i F P!

15

P! + P! 1 + i F P!

1+i C F C! y, x The optimal C! can be expressed as: y= Rearrange: y= The behavior of this function involves two cases. If the denominator has zeros, then y goes to infinity at the zeros. If the function in the denominator does not have a zero, then there will be a global maximum of y occurring at a certain x. Notice that A = B 1 and C = B
!! !! !!! (!!!)

Ax !

1 +B 1x

+C

A+B

x!

1 A, B, C > 0 2Bx + (B + C)

. After writing A and C by B, we are able to

check the number of zeros of the denominator: b! 4ac = 4B ! [1 (2 )(1 + P! )] P! + P! (1 + i)

16

Here 2 > 1, 1 +

!! !! !!! (!!!)

> 1. Thus b! 4ac < 0 and the denominator does

not have a zero. Therefore, a maximum of C0 can always achieve. As a consequence, we can draw the conclusion that a consumers anticipation of the Fiscal Cliff does have an effect on her consumption choices, but whether there is a direct mathematical relationship between the anticipatory probability and the amount of consumption in fact depends on the specific utility function of consumers. A consumer with a log utility function, knowing that there might be a tax increase in the future, will surely adjust how much she consumes today. However, the amount she optimally chooses to consumer today does not depend on how likely she thinks the event will happen. For a consumer with a square root utility function, facing the uncertainty she will choose a different consumption point other than the initial endowment point so that her total utility can be maximized. Moreover, the amount of consumption today is a direct function of the probability with which she predicts the event will happen. Therefore, our model illustrates that the influence of uncertainty on the consumers choice of consumption exists, but it is really a matter of the risk profile of the consumer. Effects of Probabilistic Government Spending Cuts As a fixture of federal spending and a recurring flashpoint of political

discourse, military and defense outlays naturally occupy much of the medias coverage of the Fiscal Cliff today. The automatic spending cuts set to come into effect beginning July 2, 2013 include a reduction of roughly $55 billion from the 17

Pentagons budget and $1.2 trillion in spending cuts over the next 10 years, creating the possibility of a severe demand shock for defense contractors in the coming year, as well as structurally lower spending1. For many contractors who depend on order flows from the federal government, this scenario is of paramount concern. Many firms depend on the federal government for a majority of their business, meaning that sequestration many mean life or death for some firms. Lockheed Martin, one of the largest contractors in the country, receives 82% of its revenue from the type of federal government spending set to be decreased by sequestration.2 Other firms have an analogous dependence on government contracts to remain viable and are justifiably concerned about their future. For this reason, contractors (small and large) have been making various preparations for the possibility of the Fiscal Cliff since its signage in 2011. In the face of this uncertainty, the five largest defense firms (Boeing, Lockheed Martin, Northrop Grumman, Raytheon, and General Dynamics) have increased their money reserves by 71% over the past eight quarters.3 While spending less because of a possible demand shock, firms in general are also bearing in mind the possible tax increases by increasing investor and intra-company payouts aimed at rewarding and assuaging shareholders in lieu of higher tax rates. The most visible contractor behavior, though, is the individual restructuring of their workforces, which has achieved little focus in recent news. 1 Congressional Budget Office, 2011 2 Linebaugh and Hughes, 2012 3 McGarry, 2012 18

Smaller defense firms the ones that are more vulnerable to cuts from the Pentagons budget4 have been laying off employees for months in order to reduce costs and prepare for decreased production, while efforts by larger contractors to do the same were complicated by a controversial rulings from the Obama Administration. In normal circumstances, a firm planning a mass layoff or a plant closing must provide warning to its employees at least sixty days in advance in accordance with the Worker Adjustment and Retraining Notification (WARN) Act. Employers failing to warn employees would leave them liable to be sued by the fired employees, which would affect production and inventories. In the case of looming sequestration, however, the Department of Labor issued a guidance letter on July 30th that the approaching Fiscal Cliff constitutes an unforeseen business circumstance and that Federal contractors need not cause unnecessary anxiety by issuing advance warnings.5 This ruling, in conjunction with a guarantee from the Office of Management and Budget that the government will cover selected legal costs of ex-employee litigation in the event of mass abrupt layoffs following sequestration, was enough to convince contractors such as Lockheed Martin to stay their hand. While yet to be formally investigated, these activities rest on highly dubious legal ground and stand a strong chance of being judged improper, which would leave contractors in the lurch. This controversy creates an additional element of uncertainty while planning future employment levels, which our model addresses below. 4 Potter, 2012 5 Cooch, 2012 19

We consider a firm in a perfectly competitive market selecting a level of production in two periods: the present, represented by T=0, and the future, represented by T=1.

T=0

MC

P*_0
Price

D_0 AVC

0 Quantity

Q*_0

20

10

T=1 MC

P*_0
Price

D_0 P(FC) D_E 1-P(FC) AVC D_1

P*_E P*_1

Q*_1
Quantity

Q*_E

Q*_0

The future period T=1 incorporates two potential demand curves representing different scenarios for the contractor: the first, Do , in which demand (encompassing contracts from the government and the private sector) remains constant at its T0 level; and the second, D1, which represents the negative demand shock of sequestration. Using consensus probabilities of the Fiscal Cliff drawn from InTrade, we can model the relative probability of each scenario occurring to determine an expected value of optimal production; a firm utilizing this method will select a production level such that it is indifferent between the two scenarios. This quantity will be lower than the T0 production level for all cases in which the probability of the Fiscal Cliff occurring is greater than zero. Delving further into the

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model, we assess how a contractor will plan an employment level contingent on this ideal production level. Once an optimal production level has been decided, the firm employs at a level that maximizes profit for the level of output. In the Fiscal Cliff scenario, firms would be incentivized to decrease employment as a response to decreased demand from the government, necessitating a draw-down in production, and an increase in the payroll tax increases the marginal factor cost of employing each worker. These two shifts are modeled in the Labor Demand graphs below:
T=0 Labor Demand

(Marginal Factor Cost) W*_0(L)

S_0(L)

Wage

(Marginal Product Revenue)

D_0(L)
0 0

L*_0(L)
Labor

10

22

10

T=1

Labor Demand

W*_E(L) W*_0(L)
Wage

S_E(L) S_0(L)
(Marginal Factor Cost)

(Marginal Product Revenue)

D_0(L)
0 0

D_E(L)
L*_E(L) L*_0(L)
Labor 10

Since wages are assumed to be sticky in the short-run, the firm would clearly be forced to cut employment (rather than lower wages) in order to maintain equilibrium in the event of the Fiscal Cliff. As in the quantity selection analysis above, a firm would weigh the relative probability of the Fiscal Cliff occurring and select an employment level such that it is indifferent between the two cases. The administrations promise that layoff notices need not be issued to fired employees (which many firms are assuming to be the case) adds an additional qualifier to the shift in total factor cost.

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10

T=1

Labor Demand

W*_E(L) W*_E(L2) W*_0(L)

Wage

(Marginal Factor Cost)

S_E(L) S_E(L2) S_0(L)

(Marginal Product Revenue)

D_0(L)
0 0

L*_E(L2)
L*_E(L) L*_0(L)
Labor

D_E(L)
10

In the event that the government is unable or unwilling to cover legal fees as a result of ex-employee litigation due to abrupt layoffs, contractors would experience a relative decrease in the marginal factor cost of each employee. That is, many firms believe that the expected cost of firing employees and having to possibly pay restitution to them is less than keeping the employees on payroll. The actual behavior of many defense contractors has closely followed the optimal actions of our model in a number of ways. The employment changes that have already occurred in the smaller firms match the predicted anticipatory shift towards a possibly new and lower employment level. Smaller firms face a relatively greater risk than the larger contractors in the event of sequestration because smaller firms may not have received the same guarantee from the Office of Management and

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Budget. On the other hand, large firms such as Boeing have been assured protection by the government and have largely maintained employment levels, seeking rather to hedge against the Cliff by increasing cash holdings and engaging in balance-sheet activities such as stock buybacks.

Anticipatory Effects on Production & Consumption The tax increases and spending cuts mandated by the Fiscal Cliff beginning in January 2013 are well understood and well modeled. As we have demonstrated, though, the anticipatory effects that our models forecast do not fall evenly on consumers and producers. We notice and document that there exists a stark contrast between the anticipatory effects of the Fiscal Cliff on consumers (household consumption) and businesses (investment demand). Our model of the probabilistic government spending cuts showed us that in this scenariowhere manufacturers are facing both defense and non-defense spending cutsmanufacturers will have fewer orders and will choose to reduce their employment level to maintain equilibrium.

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 Above is a graph of Manufacturer New Orders: Nondefense Capital Goods Excluding Aircrafts (blue) and Real Retail and Food Service Sales (red). We see that throughout times of boom and bust, they are well correlated, but beginning in early 2012 they diverge in a significant way. Around their point of divergence, InTrade was pricing in a ~35% chance of a recession induced by failure to abate the negative economic impacts of the Fiscal Cliff. As the Fiscal Cliff nears we see manufacturing drop precipitously, and initially retail sales follow down, but quickly turn around and move inversely to the drop in new orders for the first half of 2012. This drop in new orders is consistent with recessionary behavior, as the graph clearly depicts in 2008. Based on our research, this corresponds perfectly to the following to the following. 26

 Here we have New Hires: Total Private (blue) and Job Losers on Layoff as a Percentage of Total Unemployed (red). We can see why retail sales have been steady: the private sector has been hiring throughout 2012. The fact that the private sector has been hiring while facing the Fiscal Cliff is no anomaly. Personal consumption accounts for about 70% of annual GDP, while manufacturing is only about 11%. Our model correctly asserts that consumers changes in spending based on the anticipatory effects of a probabilistic tax increase depend on the risk-profile of the consumer. So while lower/middle-income households with higher marginal propensities to consumer would significantly decrease their consumption if their taxes were increased, we assert that because President Barack Obama has been resolute on not raising taxes on the middle (and lower) class, these higher

27

propensity consumers have not seen an anticipatory shift in their consumption decisions, thereby maintaining steady new hiring throughout the first half of 2012. In order to reconcile the sharp increase in recent layoffs-to-total unemployed, we need not look further than the Worker Adjustment and Retraining Notification Act (WARN) introduced above. The WARN Act mandates that employers planning a mass-layoff must give their employees at least a sixty-day notice of their termination or they are liable to be sued by the fired employees. President Obama recently nullified this WARN Act mandate, when he guaranteed employers safety from litigation, meaning that employers could fire employees immediately if spending cuts were to take effect January 2, 2013. Looking at the graph, it is clear to see that recently unemployed as a portion of the total unemployed skyrocketed in early 2012 before President Obama issued his presidential protection in July. After the protection was guaranteed, layoffs fell dramatically, as employers were no longer forced to decide whether or not to fire their employees based on a possible decrease in demand for their goods. Due to the WARN Act, employers were firing in advance to the Fiscal Cliff in order to avoid costly litigation. While the President of the United States can grant pardons and protection, as he did with American employers in July 2012, he cannot mandate confidence.

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 The blue line is University of Michigan Consumer Sentiment Survey and the red line is Purchasing Managers Index Composite Manufacturing Index. Although we only have consumer confidence data for half of 2012, we can see through the retail sales proxy (above) that household consumers are largely indifferent to the Fiscal Cliff. As we proved in our model, only risk averse and high propensity consumers would significantly reduce their consumption confidence, but many of these consumers are purchasing staples and therefore do not have the luxury of saving. Their constituent of market demand is therefore fixed, more or less. Manufacturing (production) tells a very different story. While President Obama can offset costs associated with Fiscal Cliff externalities, he cannot do anything to promise manufacturers that they will not see a drop in business. As a result, we see 29

manufacturing prices (manufacturing confidence) bottom out in late 2011 and begin to rise in early 2012, only to fall back again to new lows into 2012. We see a slight uptick around when President Obama guaranteed employers protection from litigation, but that gain was quickly wiped out as the Fiscal Cliff approaches and there is no deal in sight. This is mirrored by the recent increase in the consensus probability that the US falls off of the Fiscal Cliff, via InTrade. All in all, we have determined that the Fiscal Cliff presents more of a drag to businesses than consumers in the short-run. While a negative demand shock will reduce business orders, thus reducing employment and impacting consumption, these affects are not implicit in the anticipatory effects that we have analyzed here. We must bear in mind, though, how important the Administrations July 2012 announcement was; based on our research and the graphs above, it is clear that many firmsespecially large-scale manufacturersare keeping employees on payroll contingent on the fact that they do not see a negative demand shock. If we do in fact go over the Fiscal Cliff, we would expect to see a wave of firings, which would carry over into the welfare of the consumer and thus change the impact of the Fiscal Cliff on domestic consumption. Currently most of the costs of the anticipatory effects of the Cliff are born by producers, but this could drastically change if no deal is reached and producers are forced to decrease employment in order to maintain equilibrium and remain profitable.

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Conclusion The divergence between consumers and producers within the real economy that has stumped economists for the better part of 2012 can, at least in part, be attributed to the Fiscal Cliff, as our research shows. This is in most part due to the looming spending cuts in the federal budget, as it is production and producer confidence that has diverged negatively from consumer behavior. This does not mean, though, that the potential tax hikes that the Cliff mandates are going unanticipated. Consumers of financial assets have been hedging possible tax increases throughout recent months. It has been reported that in 2012 alone, US investors have already dodged $6billion in Fiscal Cliff-related tax revenue6. Most firms that have enjoyed this luxury are not defense or manufacturing related, but rather they are the technology and retail giants of the United States of America. This falls directly in line with what our model proves: the consumer remains robust. Whether or not tax increases will affect consumers bottom-line remains to be seen, but the anticipatory effects of such an event are not impacting Americans consumption decisions, and it is this phenomenon that is driving this economic bifurcation within the United States. Akin to the division in Washington D.C. that has brought us to this pointto this Cliffa division of equal magnitude is taking place within the US economy. As we have noted countless times, though, we have no way of knowing what the actual impacts of going over the Fiscal Cliff will be. Our models assume rational agents, making perfectly optimized decisions over time, but if the men and women in 6 According to Markit data 31

Washington dont know what will happen on January 2, we cannot expect a typical American household to have any more clarity on the subject. For this reason, we believe that if the United States is to face the full force of the Fiscal Cliff, it will surely result in a negative demand shock induced recession. As noted above with manufacturers new orders, recent trends in American production are already hinting at such an event happening. We began our exploration of the anticipatory effects of the Fiscal Cliff on the United States of America by noting that this problem began with American politicians, and probably for the worse, that is where it will end. The division that has plagued Washington has grown starker in recent years, and the divergence between consumers and producers as a result of divided leadership stands as a testament to the irresponsibility of those sent to Washington D.C. to serve their country. These divergences cannot last forever, and depending on the events of the next couple weeks, the United States is due for a reversion to the mean. The direction of that reversioneither production up to meet consumption or consumption down to meet production and confirm a recession within the United Statesis wholly on the shoulders of the politicians in Washington D.C.

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Bibliography Congressional Budget Office. Discretionary Spending. 26 Oct 2011. http://www.cbo.gov/publication/42728 Cooch, Anthony. "Providing WARN Act Notification To Employees As Sequestration Approaches." JD Supra. 30 Oct 2012. http://www.jdsupra.com/legalnews/providing-warn-act-notification-to- emplo-78006 Linebaugh, Sarah and Hughes, Siobhan. "Companies Warn About Cutbacks." Wall Street Journal 14 Nov 2012. http://online.wsj.com/article/SB100014241278873245959045781173722 70718216.html McGarry, Brendan. "Defense contractors stockpile cash ahead of fiscal cliff," Washington Post 25 Nov 2012. http://articles.washingtonpost.com/2012-11- 25/business/35508782_1_cash-defense-contractors-biggest-contractors Potter, Matthew. "Smaller Defense Contractors Are Seeing Mixed Results," Seeking Alpha 6 Nov 2012. http://seekingalpha.com/article/982101-smaller- defense-contractors-are-seeing-mixed-results United States House of Representatives. Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. Washington D.C, 111th Congress. United States House of Representatives. Budget Control Act of 2011. Washington D.C, 112th Congress.

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Mark Gongloff. "US Investors Already Dodged $6 Billion in Fiscal Cliff-Related Taxes." Huffington Post 04 Dec 2012. http://www.huffingtonpost.com/2012/12/04/early-dividends-tax- revenue_n_2237581.html?utm_hp_ref=tw

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