Standing on the Edge of the Fiscal Cliff

By:  Lori Eason, CFP(R) With the election less than two months away, emotions are running high among Americans as the two candidates battle for the Oval Office. The stakes are high as our country has been plagued with an ever increasing deficit, unemployment and a struggling economy for several years now. Our country sat back and watched as the Eurozone debt crisis unraveled with many of us fearing that we were next in line if we continued on our current path. In fact, for the past 18 months, the number one risk that worried money managers has been Europe's debt crisis. Until September, that is. In this month's Bank of America Merrill Lynch Fund Manager survey, the looming fiscal cliff in the U.S. took over the number one mega risk spot.    The fiscal cliff is the popular shorthand term used to describe the decisions Congress must make come December regarding the expiration of the Bush tax cuts and the scheduled spending cuts set to take effect in January. In 2010, Congress kicked the issues down the curb by extending the Bush tax cuts through December 2012 and postponing the spending cuts until then as well.    The Bush tax cuts are a series of temporary income tax relief measures enacted by President George W. Bush in 2001 and 2003. They lowered federal income tax rates for everyone, decreased the marriage penalty and increased the child tax credit. These cuts also lowered capital gains and dividend income rates. The estate tax gradually decreased until it reached zero in 2010. Phase-outs on personal exemptions and itemized deductions were eliminated which allowed millions of households to escape the alternative minimum tax. Another tax break set to expire that is not part of the Bush tax cuts is the 2% reduction of the Social Security payroll tax which President Obama enacted in 2011. Without an extension of these tax cuts, it is estimated that the typical middle class family would face an annual tax increase of over $2,000.    The spending cuts referred to are part of the Budget Control Act of 2011 which requires $1.2 trillion in budget cuts over 10 years. These automatic cuts will be split between security and non-security programs and include $500 billion in cuts to the Department of Defense. There will be no cuts to Medicaid and Social Security. The first $109 billion in cuts are set to take effect in January of 2013.    So Congress clearly has 2 choices: extend the tax cuts and delay the spending again or do nothing and see how things play out. With the impending election, the most likely course of action is to postpone the tax increases and spending cuts and thus kick the issues further down the curb. Let's take a deeper look at these options.    If Congress doesn't avert these tax increases and spending cuts, the Congressional Budget Office predicts that the U.S. economy will face a significant recession in 2013. The CBO estimates that the policies set to go into effect would result in a 1.3% contraction in the first half of 2013 (which meets the definition of a recession) and a 2.3% expansion in the second half. The estimated growth in real GDP for the year would be .5%. The CBO warns that as a consequence of the spending cuts, the unemployment rate is projected to rise from 8% to 9.1% by the end of 2013. Keep in mind that these figures are projections from one group and should not be taken as facts.    If you have read our past memos, you know that the United States' spending problem is one of our hot buttons and in our opinion, the number one reason our country is in such bad shape. At the end of September 2008, our total outstanding debt was $10,000 billion (I'm going to phrase this in billions because the word "trillion" seems to have lost its meaning lately). As of last month, the total outstanding debt number is now $16,000 billion. That is an increase of 60% in just 4 years! And what has all that spending done for us? Given such a dramatic increase in such a short period of time, surely our government can find some way to shave $109 billion off of next year's budget without bringing on a recession. To put it in perspective, the total outlay for this year is projected to be $3,796 billion.    Now let's shift our focus from the spending side to the tax revenue side. Allowing the tax cuts to expire would raise taxes by $316 billion on more than 100 million Americans. Maybe a better term is not fiscal cliff but taxmageddon. There's no way that this economy could digest a tax increase of that magnitude. The White House has called for a mixed deficit reduction plan which includes the extension of all the Bush tax cuts for all families who make less than $250,000/year as well as some spending cuts. Republicans disagree with the $250k income cap and argue that would be a tax hike on small business owners. Romney has proposed extending all Bush tax cuts and postponing all spending cuts until he get in office (if elected) at which point he would construct his own deficit reduction plan.    Here's our take on the tax situation. If Congress were to let the tax cuts expire for those who make over $250,000, the CBO estimates the additional tax revenue in 2013 would be around $42 billion. When facing the decision of whether to raise taxes, the cost-benefit analysis should certainly be considered. Ernst & Young predicts that tax increases on the affluent would cost around 710,000 jobs and cut wages. Raising taxes on the wealthy causes them to redistribute their capital and use it in ways that are not as beneficial to the economy in an effort to shelter those monies from taxes. The risk of higher unemployment and lower taxable incomes hardly seems worth the benefit of only reducing the current year's deficit by less than 4% ($42b/$1,130b). No amount of tax increase on the rich could ever get us out of our debt crisis. We have to get to the root of the problem which is overspending. Our government has proven time and time again that access to more revenue and credit only feeds its spending addiction.    Despite the fact that several members from both parties have said Democrats and Republicans will have to compromise to reach a deal after the election, no leaders from either party have shown any willingness to do so. And there is definitely a cost to indecision which will likely affect the economy before 2013 begins. Households and business will most likely begin to change their spending habits in anticipation of the changes, which could reduce GDP by .5% by the end of 2012 according to the CBO. One lesson to be learned over the last few years is that Americans do not respond to temporary fixes. All of these stimulus attempts over the last several years (from the random tax rebate checks we all received back in 2008 to First Time Home Buyer and Making Work Pay credits) have done nothing but delay the inevitable and add to our outstanding debt. We cannot spend our way out of this mess!    The bottom line is that with either choice, the U.S. will still be in a precarious economic situation for the foreseeable future. Our spending problem is going to take years to fix, but we have to start somewhere.  The election results in November will tell us a lot about this country and the direction it is headed.

*All projections came from either the Congressional Budget Office or Treasury Direct.