The Fiscal Cliff

The Cliffs of Moher

The American people are a resilient bunch.  Throughout the latter half of this year, we have spent more money on housing, more money on automobiles, and more money on each other during the first weekend of the holiday shopping season.  Consumer confidence is at a 4½ year high.

In spite of this, the most popular questions during client reviews this fall have revolved around the so called “fiscal cliff” we are facing at the strike of midnight on January 1st.  Let’s take some time to explore just what kind of edge we are careening toward.

What is this fiscal cliff?  The term refers to a lot of different tax and budget provisions that are all scheduled to take place automatically as we usher in the New Year.  These include:

Higher tax rates.  When the clock strikes twelve, the Bush-era tax cuts will expire, eliminating the 10% tax bracket altogether, and moving the current 25%, 28%, 33% and 35% brackets up to 28%, 31%, 36% and 39.6% respectively.  At the same time, the 0% capital gains tax rate for lower-bracket Americans would bump up to 10%, and the tax rate on dividends would rise to 15% or 28%, depending on the recipient’s income tax bracket. 

The loss of deductions–including a provision that eases the so-called “marriage penalty,” some deductions for college tuition, child tax credits, dependent care credits and a particularly harsh phase-out that would eliminate up to 80% of some taxpayers’ itemized deductions for mortgage interest, state and local taxes, and charitable donations.

Now that we have addressed how tax provisions will hit your wallet on April 15th, let’s look at the second half of the equation works.

Random across-the-board budget cuts that nobody intended to see enacted.  The Budget Control Act of 2011, the result of Washington failing to responsibly make budget changes last year, calls for automatic government spending cuts of $1.2 trillion from the federal budget over the next 10 years.  The cuts apply to just about every discretionary (non-Social Security, Medicare, Medicaid) program in Washington, although most of what you’re hearing about are reductions in the defense and education budgets.  This seems interesting considering that most of the deficit explosion and budget problems of the last 30 years were caused by the non-discretionary programs of Medicare and Medicaid.  Two programs that were failed to be addressed!

The expiration of stimulus measures:  The Obama-era payroll tax cuts will go away, raising taxes by about two percentage points for workers.

Why do we call this a “cliff?”  Because everything on that list would take money out of the hands of taxpayers and, at the same time, lower government spending.  This essentially provides the U.S. economy with the opposite of a government stimulus.  The Congressional Budget Office estimates that if we go over the cliff, a total of $560 billion would exit the economy.  The CBO estimates that this would reduce America’s total economic activity in 2013 by four percentage points.  Hello recession!  The good news about this severity is that it isn’t good for anyone.  Rich or poor, Republican or Democrat.

So what are the odds that Washington will get its act together and choose a course that doesn’t take us over the cliff?  As it happens, there is reason to hope.  Leaders on both ends of the partisan divide agree on many things in this negotiation: that the tax cuts are too painful and random to allow in their present form, and that tax rates on American taxpayers with less than $250,000 in income should continue as they are today.  The sticking points are if or how much tax rates should rise for Americans in the higher tax brackets, and where to apply the budget knife.

This rare moment of meaningful negotiation offers Washington policymakers a chance to expand the discussion and come up with a long-term solution to the nation’s debt problem, which is, after all, the topic of debate which led Congress to create this fiscal cliff in the first place.  If you’re optimistic, then cross your fingers that the leaders in the room will want to do something more with this conversation than just address the immediate problem.

Republicans are now suggesting that increases in revenue are possible, and Democrats have hinted that entitlement program changes are also on the table.  If we see real movement towards a balanced budget amendment, or at least a program implemented that requires an equal cut when something is expanded, then we will be on right track.

Thankfully things on the playground still seem relatively peaceful for now.  As long as Washington continues to get a check mark for “Plays well with others” there is hope.  A year ago this seemed unlikely, but now, the benefits of fixing things look appealing to everyone.  Maybe it will even become precedent.

So, enough with the seriousness.  It is the holiday’s isn’t it?  Occasionally amongst the riveting  financial articles I read, I find something that one can have a lot of fun with.  Consider this article on how you could have guaranteed a win in last night’s Powerball drawing:

Chins up everyone, and happy spending this holiday season!