Will the U.S. Follow the UK Off the Fiscal Cliff?

NEW YORK (TheStreet) -- As the U.S. draws ever-closer to the fiscal geological formation that is anything but a cliff, investors seem eager to handicap what might happen should politicians fail to find a workaround.

Among the most popular theories: The UK has already fallen off the fiscal cliff, and its recent recession is a blueprint for what could happen here.

In our view, this comparison is flawed -- and though we expect moderation on some of the cliff's major components (like the 2001-2003 tax cuts), the analogy's worth exploring. It's true the UK's method of deficit reduction -- moderated spending increases combined with higher taxes -- is, at first blush, similar to the fiscal changes looming at home.

However, there are key differences between the UK and U.S.'s fiscal policies, and deficit reduction wasn't the sole driver of the UK's recession -- other causes more responsible for the UK's downturn are less likely to be issues in the U.S.

Like the U.S., the UK's spending adjustments amount to more of a slope than a cliff. UK public spending has continued growing year over year, just not at the high rate initially projected. Which is similar to what the U.S. would experience under sequestration in the years beyond 2013's initial (and, rather small) $9 billion annual decline.

In fact, UK government expenditure has detracted from headline GDP growth in just one of the past seven quarters. In the U.S., however, the government spending component of GDP fell from the third quarter of 2010 through the second quarter of 2012 thanks largely to state and local government spending cuts. In that regard, the U.S. has already fallen off the fiscal cliff!

Yet, because the private sector remained robust, the U.S. economy continued growing.

In the UK, the opposite happened -- though government spending continued growing, private-sector components of GDP contracted, tilting the economy back into recession in early 2012. This was partly due to tax increases hampering consumption and business investment, but that doesn't mean the U.S. tax increases, should they come to pass, would be necessarily recessionary.

Until this past summer, the UK's top income tax rate was 50%, far higher than the 39.6% rate America's highest earners would face if the 2001-2003 tax cuts were to expire. Plus, in early 2011, the UK hiked its value-added tax (VAT) from 17.5% to 20%, eroding folks' purchasing power.

Even among the U.S. tax increases that likely won't be compromised away, such as the expiration of the payroll tax holiday and the new taxes on investment income under the Affordable Care Act, none should have the sweeping (and regressive) impact of the UK's VAT hike. Higher dividend taxes may seem problematic on the surface, but remember, firms have other means of returning profits to shareholders.

Perhaps the most important difference between the UK and U.S. is each country's regulatory environment and the impact on lending. In the UK, falling lending likely bears much blame for the private sector's struggles. Banks are lending only to the most creditworthy borrowers, largely shutting out many small businesses and entrepreneurs, making it extraordinarily difficult for most firms to invest and expand.

Banks' hesitance to lend is largely due to regulatory uncertainty. Since the government telegraphed regulatory changes in 2009, banks have anticipated having to adjust business models and increase capital buffers, but they're still waiting for clarity on the actual rules.

The government released its regulatory overhaul proposal in June 2012, but the measures still remain subject to parliamentary debate. Behind the scenes regulators are lobbying for even stricter oversight than the government proposed, including the ability to arbitrarily set banks' leverage ratios and mandate they build up countercyclical capital buffers. Faced with these possibilities, banks have incentive to hoard capital and limit balance sheet risk, not lend.

While the U.S.'s regulatory landscape isn't great, the U.S. is about two years further along in the process than the UK. The major financial legislation was passed in 2010, the rules have slowly taken shape, and banks have some clarity -- hence, U.S. loan growth, though not stellar, is picking up.

That lending is improving despite Federal Reserve programs like Operation Twist, which flattened the yield curve and narrowed banks' profit margins (and, by extension, their incentive to lend), speaks volumes about the relative health of U.S. banks and their ability to continue funding corporate America.

As long as U.S. firms can continue securing funding, whether through banks or primary debt markets (where yields are at historic lows), there's plenty of fodder for future expansion and growth.

Even though we expect Congress to find a workaround for at least part of the fiscal cliff, some tax increases and budget cuts will likely take effect, and there will be winners and losers. Less government spending gives the private sector more room to grow and compete, but higher taxes can make it incrementally more difficult for private firms to step up.

However, in our view, the U.S. economy appears well positioned to weather these changes. The UK's experience simply isn't analogous.

Importantly, for investors, U.S. tax increases and spending cuts shouldn't have a lasting impact on global markets. They're too widely known and too localized (not to mention tax changes haven't historically correlated with market returns).

In our view, plenty other global positives should continue pushing this bull market forward.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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