Posted by Shyam Moondra
Since Ben Bernanke, the FED Chairman, first coined the term “fiscal cliff” last February, it has taken its own life and is now being used universally by the media and investors around the world. The term “fiscal cliff” refers to the convergence of the expiration of a variety of tax cuts (e.g., the so-called Bush income tax cuts, temporary payroll tax cuts, estate tax cuts, and investment tax cuts) and across-the-board spending cuts (equally divided between defense and non-defense discretionary expenditures) on January 1, 2013. At that time, additional health care taxes related to the Patient Protection and Affordable Care Act of 2010 would also go into effect. These automatic tax increases and spending cuts (known as “sequestrations” in the Budget Control Act of 2011), if carried out in full, could reduce budget deficit/debt by as much as $7 trillion over ten years. Bernanke has warned that these precipitous tax increases and spending cuts at a time when economy is still recovering at a tepid pace could push us into another nasty recession. The investors are very skittish about the impending catastrophe and they are reacting to every word uttered by Republicans or Democrats on the status of negotiations to save the country from falling off the “fiscal cliff.” Most corporations have put their plans for capital investment and hiring on hold until there is more clarity on if there is political will on the part of Republicans and Democrats to compromise and come up with a more modest deficit reduction plan of the order of $1.2 trillion over ten years (as required by the Budget Control Act to avoid automatic tax increases and spending cuts) before the end of the year (actually, within the next three weeks before the Congress adjourns for the Christmas holidays).
President Barack Obama has proposed a budget plan which would increase taxes by $1.6 trillion (the Bush tax-cuts for the middle class would be made permanent while tax-cuts for the rich would be eliminated along with investment and estate tax cuts) and reduce spending by $600 billion over ten years for Medicare, Medicaid, farm subsidies, and other programs ( these spending cuts are over and above $1 trillion of spending cuts that the president and Congress committed to last year for the coming decade and a reduction of $800 billion in projected war spending, reflecting the winding down of the U.S. combat operations in Afghanistan and Iraq). House Speaker, John Boehner, has called Obama’s plan as not “serious.” Republicans don’t want to increase tax rates for the rich (although they are open to reducing deductions to have a net increase in tax revenues by a smaller amount than what Obama wants); they want to rely primarily on deep spending cuts in the entitlement programs to balance the budget, which is vehemently opposed by Democrats. So, lines have been drawn in sand by both sides; they are miles apart and very little time is left to bridge the gap before the country goes over the “fiscal cliff” in less than a month.
Implications of “fiscal cliff”
Below are some observations on where things stand in the aftermath of the November elections and what “fiscal cliff” means to both Democrats and Republicans:
• Obama fought the election based on his vision of reducing budget deficit/debt by increasing tax rates for the rich (those making at least $250,000 a year) while preserving the lower tax rates for the middle-class. Not only Obama got re-elected, but his policy platform also brought net gains for Democrats in the Senate and House. Democrats view these election results as a mandate on their tax and spending policies. The post-election polls also show that voters overwhelmingly support Obama’s vision of balancing the budget by increasing taxes and closing loopholes for the rich. Republicans are clearly in a much weaker position now than they were before the election.
• Republicans believe that higher taxes on the rich will negatively affect economic growth and hamper job creation. The historical data, however, doesn’t support these assertions. Trickle-down economics was enacted by Republican Presidents Ronald Reagan and George W. Bush, and both times we ended up with recessions and high unemployment rates. On the other hand, when Democratic President Bill Clinton raised the income tax rates for the rich to the highest levels in modern history, he not only achieved a budget surplus but his policies brought sustained prosperity for people from all walks of life for a decade (with unemployment rate falling down to as low as 4.5%, which economists consider as “full employment” level). Therefore, the pro-rich agenda of the Republican Party doesn’t resonant with the electorate.
• Obama wants the top individual tax rate to go up from the present 35% to 39.6%. However, the fact of the matter is that very few rich individuals pay the highest rate because of all kinds of income exclusions and deductions that have been added to the tax code over the years, mostly by Republicans who favor the rich (rich individuals reciprocate by showering Republican candidates with lavish amounts of campaign contributions). The problem is illustrated by Mitt Romney, who earned tens of millions of dollars a year but paid as little as 13% in federal taxes during the last ten years, thanks to his aggressive use of income exclusions and deductions. Increasing the top marginal rate by itself is not going to do much good unless, at the same time, the tax code is simplified and most income exclusions and deductions are weeded out.
• Obama won the election because his vision enabled him to put together a winning coalition consisting of women, Blacks, Hispanics, young voters, veterans, and middle-class white voters. Due to demographic changes, the continuing growth in the Obama coalition will only make it harder for the Republicans to win elections in the future, if they continue to stick to their philosophy of unproven trickle-down economics. That means Republicans are better off to negotiate the best deal they can get now.
• If Republicans choose to let the country fall off the “fiscal cliff” (let all tax cuts expire and automatic spending cuts go in to effect), most economists believe that economic growth will decline, pushing us back into recession with unemployment rate rising again. The automatic tax increases would, however, technically not count as Republicans’ violating their pledge to not increase taxes (because they wouldn’t really vote for tax increases). And then in 2013, when the next Congress convenes, Republicans could vote for a tax cut for the middle-class, which doesn’t violate their tax pledge either. However, higher unemployment rate, crashing financial markets, and possible downgrade of the rating of the U.S. government securities by rating agencies could lead to a backlash against Republicans in the Congressional elections of 2014. The voters could give Democrats a filibuster-proof majority in the Senate and the control of the House. With Democrats in charge of the presidency, Senate, and House, Obama could then swiftly move to implement his agenda in the last two years of his second term. An increasing number of Congressional Republicans are beginning to realize that their firm posture on extending Bush tax-cuts for the rich may not only push the country off the “fiscal cliff,” but it may in fact push the Republican Party off the cliff. In a post-election survey concerning the “fiscal cliff” conducted by Pew Research Center, about half of respondents believed Congress will fail to reach an agreement to reduce the country's budget deficit compared to only 38% who said a deal will be met. If the two sides fail to find common ground on reducing the deficit, 53% said congressional Republicans will be to blame while 29% said the responsibility will fall on Obama.
• In a strange way, if there is no compromise between the Democrats and Republicans over the “fiscal cliff” before the end of the year, some investors might think of this as a positive development. While “fiscal cliff” would cause reduced consumer spending and economic slowdown in the near-term, the budget deficit and debt situation would be greatly improved in the long-term. If the automatic tax increases and spending cuts of January 1, 2013 are carried out in full, they will reduce deficit (or avoid debt) by $7 trillion over ten years. This will go a long way towards putting our national financial house in order, which will be very positive for the long-term economic growth. Therefore, in the short-term, the stock market may decline, but the chances are that it will bounce back rather quickly. In 2013, Republicans and Democrats may hammer out a $4.5 trillion plan, as originally envisioned by Obama and Boehner last year, which incorporates higher taxes for the rich and lower taxes for the middle-class and meaningful reforms of the entitlement programs. Such a breakthrough plan could push the financial markets to record high levels.
Possible Comprehensive Deficit/Debt Reduction Plan
The following could form a basis on which to work out a comprehensive plan to reduce deficit and debt:
1. Taxes:
o Make Bush tax cuts for the middle-class (family income less than $250,000 per year) and small businesses permanent.
o For high-income earners, let the Bush tax-cuts expire and also limit income exclusions and deductions to $35,000 (as suggested by Romney). As an alternative, impose AMT of say 25% of gross income, so all rich people will pay a minimum of 25% in taxes. When Romney pays only 13% or Warren Buffett pays only 20% in federal taxes, it's just morally wrong.
o Capital Gains/Dividend Taxes: These Bush tax breaks encourage saving and investment, and they also benefit the middle-class. Therefore, they must be made permanent.
o Estate Taxes: These taxes should be increased, but not by as much as what liberals want. Republicans and Democrats should find a compromise.
o Corporate tax loopholes must be closed. It's wrong when GE pays 0% and Google and Goldman Sachs pay only 10% in federal taxes. Our corporate tax rate may be high, but the reality is that most companies don't pay anywhere near the top rate. We need a plan that would make corporations pay a lot more in taxes than they are paying now - we need to close down all the loopholes that companies use to reduce their tax liabilities.
2. Health Care: Revisit the Obamacare and make some adjustments to provide relief to small businesses.
3. Entitlements:
o Medicaid: Medicaid is the worst program ever created by the federal government. There is so much potential for fraud that this program, in its current form, can't be sustained by the taxpayers. Many poor people are using Medicaid fraudulently to put some cash in their pockets. They visit doctors and undergo unnecessary treatments and, in return, some doctors and other service providers share part of their fee paid by Medicaid with the patients. Medicaid was intended to provide health care for the poor people, but some of them are using it as a cash-cow. No amount of enforcement will ever catch this kind of fraud. As the health care costs continue to go up and health care becomes unaffordable, more and more people would end up in Medicaid. Therefore, there is simply no way this program can be viable in its current form for the long-term. The federal government should give a fixed grant to the States (increased over time to keep up with the general inflation rate) and let individual States administer health care for the poor.
o Medicare: There should be no change in retirement age. We could increase the deductible and the Medicare tax rate and make benefits a function of income (rich people get minimum Medicare benefits or no benefits at all). There should be increased funding for fraud prevention. There is no support for the Republican idea to convert Medicare into a voucher program.
o Social Security: There should be no change in the age requirement or COLA calculations. We could increase the income limit which is subject to social security tax and we could make benefits a function of income (rich people get reduced benefits or no benefits at all). There is zero support for Republican idea to privatize Social Security.
4. Provide increased funding for Education. The U.S. students are sliding down fast in test scores compared to other countries which will negatively affect our competitiveness in the future.
5. Our infrastructures are crumbling (bridges, highways, roads) - during the recent Hurricane Sandy, we saw how antiquated our power grid and telephone infrastructure are. The government and corporations need to step up and modernize the infrastructure. We could impose a special tax on gasoline to pay for increased investment in our infrastructure.
