Averting the Fiscal Cliff
In the end, it came down to the wire.
Ever since the November elections, Congress has worked to avert the “fiscal cliff.” Quick recap: the fiscal cliff is—or would have been—a series of automatic government spending cuts coupled with the expiration of the Bush tax cuts. Taken together, this combination of diminished spending, along with increased tax revenue, meant that our national deficit would have decreased by $4.5 trillion over a ten-year period. But it also might have sent our economy into another recession. Why? Because the automatic spending cuts would have probably resulted in fewer federal jobs, increasing unemployment. Meanwhile, the tax hikes would have lessened the amount of money people spend on goods and services. For that reason, both Democrats and Republicans were opposed to seeing us “go over the cliff.”
But while both parties agreed there was a problem, neither could agree on a potential solution. As November turned into December, and the year drew to a close, it looked more and more like gridlock would prevail. Christmas came and went, and still no deal. The fiscal cliff was due to hit on January 1st … at midnight.
Enter Vice-President Joe Biden and Senate Minority Leader Mitch McConnell. The two men met to personally hammer out a deal on December 31st(talk about leaving it to the last minute!) Their agreement was quickly passed in the Democrat-controlled Senate, then more narrowly in the Republican-dominated House on New Year’s Day.
So here’s what the deal looks like:
· What Will Happen: Income tax rates will rise to 39.6% for all individuals making over $400,000 a year, and all families making over $450,000. No other income tax rates are affected. What Would Have Happened:Income tax rates would have risen for everybody.
· What Will Happen: Payroll taxes will rise by 2%. What would have happened: The same. In 2010, a payroll “tax holiday” was enacted that lowered payroll taxes by 2%. It was always due to expire in 2013, and neither side made any attempt to change that.
· What Will Happen: The tax rate on capital gains and dividend income will rise to 20% (up from 15 %) for individuals making $400,000 a year and families making $450,000. The rate remains the same for all those making less. What Would Have Happened: Taxes on capital gains would have risen to 20% for everyone, and dividends would have been taxed as ordinary income.
· What Will Happen:The estate tax will rise from 35% to 40% for estates worth over $5 million. What Would Have Happened: The estate tax would have risen to 45% for all estates over $1 million.
· What Will Happen:Limits on some tax exemptions and deductions for individuals making $250,000 a year, and families making over $300,000. What Would Have Happened: Nothing. The fiscal cliff had no automatic provisions for changing exemptions or deductions.
What the Deal Didn’t Cover
Remember that there were two parts to the fiscal cliff: tax hikes and spending cuts. For the most part, this deal only covered the tax portion. The spending cuts, on the other hand, will be delayed for two months. The good news is that government departments can avoid painful layoffs for at least a little longer, helping our unemployment rate. The bad news is that Congress is in for another bruising argument in March, only two months away. There’s no way to know what the outcome will be.
Another important topic the deal didn’t cover is our debt-ceiling. The debt-ceiling is the maximum amount our government can legally borrow. As of December 31st, we’ve already reached the limit. Thanks to a few tricks and loopholes, the government won’t actually exceedthe limit until February 28th, but those tricks are merely a band-aid on the overall problem.2 Once March rolls around, Congress faces three options:
· Raise the debt-ceiling again, which Republicans do not want to do.
· Default on their debt, which could lower our credit rating again, as well as make it harder to borrow money in the future.
· Make drastic spending cuts, which is what the fiscal cliff would have done in the first place.
So what does all this mean for you?
At the very least, we’ve averted a second recession … for now. With the bulk of the tax hikes canceled, consumer spending shouldn’t be affected by too much. That’s definitely a good thing. And the markets have reacted positively. On January 2nd, 2013, the Dow rose 210 points after opening while the S&P 500 rose 1.8%, and the Nasdaq 2.4%.3 Whether those gains last or not depends much on whether Congress can compromise on spending cuts the way they did on taxes.
But for the long term, massive problems remain. Our national debt is still over $16 trillion. The fiscal cliff would have shrunk our deficit substantially, but the deal provides only $600 billion in new revenue over 10 years.4 When you consider that our national deficit for the year 2013 alone is expected to be 1.1 trillion, those are pretty sobering numbers.
In the end, Washington chose to go with a short-term solution to fix a short-term problem, leaving the long-term problems untouched. More decisions need to be made, and soon. For the moment, we can all bask in the knowledge that at least Congress got something done, but as long as gridlock remains, so too will economic uncertainty. And it’s uncertainty that makes the markets nervous. Still, we as a country needed to avoid the fiscal cliff. As of right now, it appears that we have.
This is a complex topic. Too complex, in fact, to adequately cover in a single letter. So if you have any questions as to how the fiscal cliff deal affects you, or what happens next, please give me a call. I’d love to speak to you in person. In the meantime, rest assured that we’re watching both Washington and the markets closely. If we feel that the aftermath of the fiscal cliff deal is going to impact your investments, we’ll notify you immediately. In times like this, the best thing to do is simply be alert. So as 2013 goes on, that’s exactly what we’ll be.
Have a Happy New Year!
Barry Misbin Rob Radoccia
2 Rich Barbieri and Jeanne Sahadi, “It’s official: US hits debt ceiling,” CNN, January 2, 2013. http://money.cnn.com/2012/12/31/news/economy/debt-ceiling/index.html?iid=HP_LN
3 Maureen Farrell, “Stocks rally into 2013,” CNN, January 2, 2013. http://money.cnn.com/2013/01/02/investing/stocks-markets/index.html?iid=Lead
4Matt Smith, “The fiscal cliff is nigh; Senators strike deal, House won’t vote,” December 31, 2012. http://www.cnn.com/2012/12/31/politics/fiscal-cliff/index.html