The Smart Money: 'Cliff' or 'Slope'?

Posted Wednesday, December 12, 2012 in Analysis

The Smart Money: 'Cliff' or 'Slope'?

by Gina Hamilton

With all the hand-wringing that's going on about the so-called fiscal cliff, no one is really stopping to discuss what going off the "cliff" would really do and what the political implications for early in the new year would be with regard to it.

Conventional wisdom says it's a really, really, terrible, horrible, very bad thing. It could cause another recession, warn some economists. And this one would be really, really bad.

But is that true? There are certainly some aspects to the fiscal cliff that could cause serious problems, but it's not a foregone conclusion that they would happen. Let's take a look at what is likely to happen if Congress and the White House are unable to compromise between now and the end of the year, and look at some hard political realities that would or could happen in the new year.

The Tax Cuts Expire

The Bush-era tax cuts are set to expire for everyone beginning Jan. 1. In addition, the payroll tax (the part of your paycheck that goes to pay for Social Security) begins to be taken out again in full on that date. 

But both were, after all, supposed to be temporary measures. The Bush tax cuts, both for income tax and capital gains, were supposed to sunset in 2010, and the payroll holiday, which cut the amount workers pay by 2 percent, was a one-year deal that was supposed to expire at the end of 2011, and then was extended for another year. 

With Social Security in need of funding, there is virtually no political will to extend the holiday for another year. The reasons are simple: Democrats worry that the $100 billion per year is needed to pay pressing bills to the retirement fund; Republicans worry that the payroll holiday smacks of "stimulus," something they contend doesn't work. 

But it is a stimulus, and to the extent that the working classes spend every dime that flows through their hands, it is working. The payroll tax holiday provides an extra $20 per week, on average, for real working- and middle-class taxpayers. Not a fortune, but enough to pay for half a tank of gas for the week, maybe, enough to pay the electric bill, or a month's worth of the kids' milk money. For the working poor, this holiday was a pretty important tax break — far more important than most of the middle-class tax credits that continue to be available. 

The other tax cuts that will be going away will be the rate cuts that date from 2001 and 2003, which brought the highest marginal tax rate down from 39.6 percent to 35 percent, and smaller cuts for the rest of us. For the average household, the loss of the Bush-era tax cuts will be an effective tax increase of about $2,000 per year. 

Also slated to go away is the cut in the capital-gains tax rates. The short-term rate is 15 percent and will rise to 20 percent, where it was before the Bush tax cuts. But the long-term rate had dropped to zero for people in the 10 to 15 percent brackets. In some cases, long-term rates will rise to 20 percent; but taxes on dividend income will rise to the income-tax rate, which could be as high as 39.6 percent. For investors, especially those who derive income from investments, this amounts to a huge tax increase.  

However, no one will be hit with the capital gains' increases until they pay their taxes for 2013, which will happen in April of 2014, so the economy will have time to adjust ... or not ... before that occurs. This is one issue where Wall Street will finally suffer more than Main Street.

How the tax cuts' evaporation will affect the economy, which is slowly strengthening, is anybody's guess, but the conventional wisdom is that the loss of the payroll-tax holiday will hurt the working classes disproportionally. The average middle-class household will have a tax hit of an additional $1,000 to $1,500 per year, depending on investment income. The wealthy will take the biggest paper hit, but will also be better able to absorb it; people earning $500,000 are expected to pay $3,300 extra in federal income tax alone; millionaires will pay more than $150,000 more in total when dividend income and estate tax is taken into consideration, according to the nonpartisan Tax Policy Center.  The reason for the disparity is that the higher tax rates will only affect income above $250,000 per year. All income up to that amount will be subject to the lower income-tax rate.

The Political Reality

Although the payroll holiday will likely go away, it is President Obama's intention to replace it with tax credits for lower-income workers. The payroll-tax holiday replaced a stimulus program called "Making Work Pay" in 2009, and it is likely that some variation on that theme (or adjustments to the Earned Income Tax Credit) will be added in the new year. It won't have the immediate stimulative effect that the payroll holiday had, but it will create a small stimulative windfall for low-income workers at the end of the year. 

If all the tax cuts expire, House Democrats will move quickly in the new year to reinstate tax cuts for the middle classes. They will do this through a process called the discharge petition, which has already been filed in the House. They need a number of Republicans to join with them to force a vote on the middle-class tax cuts (they will need fewer in the new year) to override Speaker John Boehner's unwillingness to call an up-or-down vote. In the Senate, there is already discussion of ending the filibuster threat to keep bills from coming to a vote. Right now, the Senate needs 60 votes to pass anything at all. What the new filibuster rules will do, on Day One of the new session, is force the obstructing party to actually perform a filibuster ... that is, to keep debate open by speaking on the floor, potentially forever. That is unlikely to happen, so compromise will once more become the order of the day. That's the theory, anyway.

Republicans don't want to vote for a tax increase for a number of reasons. One is the notion that tax increases hobble the economy. However, the so-called "job creators" have had more than a decade to prove that theory, and so far, the jobs aren't being created with the tax breaks the wealthy have received. The other problem is that Republicans, by and large, have signed a no-tax-hike pledge with Grover Norquist, president of a conservative organization called Americans for Tax Reform. Norquist's organization has moved against Republicans who have either not signed his pledge not to raise taxes for any reason, or who have signed and reneged on the pledge. 

However, it will be easier for them to vote for a tax break (for the middle class in the new year) than to vote for a tax increase (on the wealthy before the end of the year).  They are also hoping to tie the tax rises with substantial entitlement "reform" ... for example, an increase in the Medicare eligibility age from 65 to 67. Obama is reportedly mulling the idea, since it would be less painful to the recipients (who would be covered in the meantime by employers or by state Medicaid) than other entitlement changes.  While cutting two years of Medicare to the youngest and presumably healthiest seniors would save about $5.7 billion, the costs increase across the economy and would cost employers, states, and medical providers some $10.9 billion over the same period.

Across-the-Board Spending Cuts

Part of the plan to raise the debt ceiling in 2011 involved onerous cuts, known as the sequester, across the board for deficit reduction, both to non-entitlement domestic spending and to military spending. This kind of bomb in the middle of negotiations was supposed to force Congress to compromise and develop a plan everyone could live with, but unfortunately, that didn't happen, and the debt ceiling was lifted with the huge cuts to programs in the budget. 

The Political Reality

No one wanted or likes the spending cuts. Essentially, they're a cleaver to the budget, where the finest of scalpels is called for. However, they will take effect in 2013 unless Congress and the White House can agree to stall them. Fifty percent of the cuts will affect the military, chopping more than $54 billion from its budget in the midst of wartime.  An equal amount will face domestic programs, including extended unemployment. All of this is occurring at a time when most economists say that stimulative spending should increase. 

The House and Senate Democrats have been pushing for unemployment extensions. That may occur, especially since it will be a huge black eye for Republicans if they stymie the program the week after Christmas. However, other domestic policies aren't likely to get the same benign treatment  While in-country military spending will continue, ancillary programs ... such as medical insurance for dependents stateside ... may be slashed. The morale issues that would raise will drive the two sides back to the bargaining table, as soon as the furor dies down over the tax-cut lapses.

The Debt Ceiling

Although not really part of the fiscal cliff, the debt ceiling will have to be raised again, probably in February or March. Democrats want to eliminate the ceiling, especially during a weak economy; Republicans don't want to raise it. Without a lifting or elimination of the ceiling, the U.S. will default on its debts, which is unconstitutional and will definitely spark a worldwide recession or even depression.

The Political Reality

This is basically the same position the two sides started at in the summer of 2011; however, with the new Congress, Democrats have some leeway. The Senate, with its new filibuster rules, will likely be able to push through a debt-ceiling increase. The House Democrats may be able to force a discharge petition through on the issue. If all else fails, there are unilateral steps the president can take. Because servicing the debt is a constitutional issue, especially under the 14th Amendment, the president can invoke an executive order to force the Treasury to continue paying the debt as though Congress had appropriated the funds and lifted the debt ceiling. There is talk of minting a single trillion-dollar coin, which would be deposited into the Treasury and used to pay bills. There are other options as well, though all hope that a political compromise can be reached in time.

In short, the fiscal cliff may not be as serious an issue as we are being led to believe. It will be a serious problem if nothing is done for people on unemployment, and the poor, but for the rest of us, it will be less of a "cliff" than a "slope." We'd still be going downhill, but the economy should survive it.

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