The term fiscal cliff comes with a degree of shock value — and it has certainly been making headlines in the U.S. But for many, the definition and the implications of the current publicized crisis are a bit of a mystery.
Like most political issues, this one has at least two sides. What is the fiscal cliff, and why is it important?
There are multiple issues at stake, none of which alone would constitute a cliff. Put them all together, however, and they present a serious economic and political problem for the U.S.
Expiration of the Bush tax cuts
When the Bush-era tax cuts were passed about a decade ago, they were structured to expire in a way that would minimize their apparent effects on the deficit, as well as ease the political debate. They were scheduled to expire at the end of 2010 and ended up being extended due to the weak economic environment.
Letting the Bush-era tax cuts expire this year would raise taxes to levels that last prevailed in the early 2000s and bring in approximately $320 billion of tax revenue.
Although more tax revenue would help the deficit, taxpayers would have less money to spend and U.S. gross domestic product (GDP) would suffer as a result.
Recently, President Obama proposed extending the cuts for families making less than $250,000 per year.
Expiration of the payroll tax cut
This tax cut, designed to put more money in workers’ pockets, was passed in 2010 as part of the two-year extension of the Bush tax cuts; it involved a temporary cut in the employee social security tax rate from 6.2 percent to 4.2 percent. Like the expiration of the Bush tax cuts, getting rid of the payroll tax cut would help reduce the deficit, but would also drain money from the spending economy.
Because of Republican objections to the payroll tax cut’s effectiveness in encouraging growth, as well as general concerns about whether it is a good idea to use social security funding as a means to attempt to grow the economy, it’s unlikely that this tax cut will be extended.
New health care reform taxes
Health care tax increases will not hit lower-income taxpayers, but they will have a material effect overall, raising an estimated $18 billion from a new 3.8 percent tax on investment income for families with incomes greater than $250,000.
The largest overall effect will come from the Budget Control Act, which enables legislation for the sequestration cuts mandated by Congress last August as part of the compromise to raise the debt ceiling. Amounting to more than $2 trillion over 10 years, the effect of sequestration in the near term is estimated at approximately $100 billion per year. It includes significant cuts to both defense and nondefense programs.
Although some effort to change the terms of the sequestration is likely, both political parties are committed to spending cuts overall and are unlikely to come to terms over reallocating defense/nondefense cuts in the next few months — or at all.
Another major item, although not part of the sequestration cuts, is the pending expiration of emergency unemployment benefits.
What does it mean for the economy?
Individual estimates of the effects of these fiscal cliff components differ; however, the total impact on the U.S. economy is projected to be around $600-$650 billion, or approximately 3.5 percent to 6 percent of GDP.
This is a big number. With growth at around 2 percent at best, the changes in taxes and spending would, at a minimum, put us back into recession.
Keep in mind that Congress does not have to do anything to make this happen; it will happen unless our elected representatives act to stop it. The best that can be hoped for is that our politicians kick the can down the road and let the President and Congress deal with it.
What about the debt ceiling?
Although we avoided default last summer, we came as close as we ever have. The compromise was to raise the limit to a point that would defer the debate until after the election.
It hasn’t quite worked out that way. The spending cuts, which were originally conceived as a punitive incentive for Congress to reach agreement, are now pending. In addition, it is now expected that we will hit the debt ceiling before the election.
So, now what?
Most likely, Congress will extend the Bush tax cuts for at least one more year and reduce some of the pending spending cuts. That said, it is unlikely that we will see a full elimination of these changes, which means that taxes will most likely be going up and spending will be cut, with consequent negative effects on the economy.
The upside is that these changes will go a long way toward solving the deficit problem. This could have extensive collateral damage in the short term, but it would make way for an unseen benefit in the future.
Contact Kevin Dick Investments at (928) 474-4350.