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: http://www.cnbc.com/id/49981575

Chins up every­one, and hap­py spend­ing this hol­i­day sea­son!