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How steep is the fiscal cliff?                                                                                     Print this essay

Posted at: Dec/10/2012 : Posted by: mel

Related Category: Economics,

With the November 2012 election behind us, President Obama is again seated in the oval office. Yet the Republicans still control the House of Representatives. It would be easy to argue that the election resolved nothing and despite the rhetoric, no one actually got a clear mandate from the people.

In the spirit of the status quo, we still have all the same personalities facing off at the negotiating table and the purported “fiscal cliff” is looming. I thought I would delve into the obtuse and try to understand the fiscal forces at work here. In the process of my analysis, I hope to also understand just how steep this cliff really is.

With respect to most households, the cliff is really more of a gentle slope because expiring tax cuts don’t hit in a single day. The average weekly tax bill would go up roughly $40-70 a week ($2040-3640 annually). Unfortunately, there is a lot of range in these numbers because the Bush era tax cut varied depending on income level and deductions. Fortunately, while it is painful, $40 per week is easier to manage than $2000 all at once.

Financial markets are already down since the election. This is mostly a worry issue by stock investors over a potential increase in the capital gains tax rate. Far better to sell now at the current rate, then wait till after the first of the year and likely pay a higher tax rate on the stock investments. Unfortunately, this obviously takes money away from corporations for internal investment and potential job creation.

The bigger concern is what the potential reaction will be from the bond market. Currently investors are buying Treasury debt at record low interest rates. If these same investors (national and international) begin to fear that the U.S. government has lost control of its finances, those rates could go higher. Higher rates would be very bad news for the economy because bonds are used to generate a steady income flow to compensate for the irregular tax income flow and thereby meet our recurring obligations such as salaries.

There has been a lot of talk about raising taxes on the upper 1% and closing loopholes to draw down the deficit. While more taxes from the richest 1% would be nice, it won’t close the budget by any measurable degree. I would much rather have the richest Americans investing in business and industry to create more jobs. Closing loopholes sounds nice when making a speech, but is much more challenging in reality. Congress has spent 60 years assembling a complex web of tax breaks and loop holes. Whether oil industry subsidies, farm subsidies, charitable contributions or the mortgage interest deduction; they all sound good until they hit you personally. In truth, they all either directly or indirectly trickle down to the consumer to pay or enjoy the benefit from. It is important to understand that in our economy, big businesses don’t actually pay taxes, they are expenses folded into the cost of doing business. Only consumers and small businesses ultimately pay taxes.

Most of us are trying to live month to month, and planning the impact on our monthly budget of some of these proposals is daunting. I studied 2 different proposals and the related evaluations from 3 different economists; each economist had a different impact. If the experts can’t agree, I likely won’t understand it until faced with my form 1040. Our federal budget is written with a set of math and accounting rules that very few people on the planet understand. Determining the line by line impact of the myriad of changes that are likely to be implemented is going to be daunting.

Our accumulated tax breaks come in the form of rate reductions, additional tax deductions, refunds and specialized credits. I don’t want to have to pay any more than I have to, but honestly…some of these fiscal incentives border on ridiculous. For some of our lower income households there is a tax device called an income credit. As currently implemented, this allows some people to get a tax credit or refund that exceed what they could have ever possibly paid. Living in America is an expensive proposition and the notion of giving it away to some at the expense of others offends me.

This will likely also be the worst tax filing season in decades as the new laws are interpreted, and re-interpreted right up to April 15. When people go to their tax accountants, they expect solutions, as these changes evolve and re-evolve; no one is going to be able to provide good tax advice. It is a safe bet that there will be a record number of tax filing extensions this year.

If no deal is reached and sequestration does hit, most government services will continue without interruption. I am confident that social security and federal paychecks will continue to go out like normal. For government employees and contractors, the bigger question is whether their agency that by law have to cut spending will begin sending out layoff notices to their workers. Layoffs are unlikely on day one of 2013. Unfortunately, the projected spending cuts are deep and each government agency has broad discretion on how quickly to make them provided they meet their annual budget target. There are likely to be some agencies that do nothing with the expectation that a 13th hour deal will be reached.

As if things couldn’t get any worse, the current debt ceiling is likely to be reached sometime in January depending on December tax revenues. The July 2011 debt ceiling debacle is what created the current fiscal cliff and the sequestration plan, who knows what games and gimmicks Congress will try next.

It is important to understand that the Federal Reserve has used just about every bullet it has. With interest rates a record lows, the government is paying less interest on $16 trillion in debt for 2012 than it paid on $10 trillion in 2008. As anyone with a credit card knows, eventually the rates will start to go up. The debt ceiling is really a legal technicality: If your lender increases the limit on your credit, you don’t owe any more money. The bigger question is whether you have the discipline not to go out and spend to your new limit.

Federal Reserve policy and the Congressional deficit debacle are certainly concerns, but I don’t believe they are the core of our fiscal woes. Most of the recent Federal Reserve policy is more a reaction to the once-in-a-lifetime financial collapse of 2008.

I believe that underlying cause of our current debt crisis is common in varying degrees to nearly every country in the developed world. This underlying cause is increased human longevity. Bad banking practices of the 1995-2008 eras merely accelerated bringing these problems to the surface. When Medicare and Social Security were created, no one expected people to live as long as they do. This has made all state-funded health care and income assistance substantially more expensive than anyone anticipated when they were designed. Unfortunately, no politician will ever get re-elected on a platform of cutting these programs. Obviously, none of us want to give up on the expectation that these programs we have been paying into will exist when we are old.

An intelligent and balanced federal budget is something that this country has needed for decades. While some spending cuts and more efficient government may ease some of our burden, they will not ultimately solve our current debt issues. Debt is really more intelligently measured when compared to size of the economy. If you owe $40K on credit cards and earn $50K annually, you have a problem. If you raise your income level to $70K, servicing that debt is not near as much of a burden and it is easier to sleep at night. This same understanding holds true for national budgets.

The other concern with the potential fiscal cliff is international credit worthiness and value. Despite the recurring anti-American attitude, most of the world invests in America. America is generally viewed as the safest and most stable investment in the world. Going over the cliff will put major cracks in that image and potentially open up opportunities for other countries including China to become viewed as an international financial center.

Tax increases and reduced government spending will only slow the economy still further, making that fiscal cliff steeper. There will be a time in the future to increase taxes and transfer jobs from the government sector to the private sector. Right now, we need to keep as many people working and spending as possible. Government needs to be asking what it can do to get out of the way of business and its related private sector job growth. Over all, the more people working and spending, the bigger that national economy and the less of a burden the debt becomes.

We may not be facing an actual cliff, but without serious bipartisan discussion, we have a pretty rocky down hill slope to contend with.

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Mick Jagger
It's alright letting yourself go, as long as you can get yourself back.
 
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