The Deadline has Come and Gone. ‘Fiscal Cliff’ Update

As anticipated, US lawmakers reached an 11th hour agreement last night, which prevents tax rises of $600 billion and across-the-board spending cuts; the deal removes immediate pressure to prevent the fall back into a recession. While it deals with some issues of concern, it by no means addressed the largest issues facing the economy, and so is seen as a sort of ‘bridge’ deal to allow some time and room for maneuvering until a comprehensive deal can be reached in two months time.

The deal has averted some of the immediate concerns making up a portion of the ‘Fiscal Cliff’, such as

•  tax cuts for individuals earning less than $400,000 have been made permanent.
•  $65bn of automatic spending cuts for have been postponed for two months
• benefits, worth $26 billion, for the long-term unemployed will be maintained for another year
• an $11bn cut in Medicare payments has been postponed for another year.

Some tax increases were allowed to pass, including:

• The Bush-era income tax cuts for individuals earning over $400,000 is expired, with the top rate increasing from 35% to 40%
• Certain income tax deductions for individuals earning more than $200,000 are phased out.
• higher taxes on dividend income, capital gains and inheritance for these same top earners
• The expiration of the payroll tax break, raising payroll taxes from 4.2% to 6.2%. The expectation is that $95 billion in additional revenue will be raised from the tax increase.

In many ways, as we’ve expected, the deal is a kick-the-can-down-the-road approach to solving overspending by the government.  While economists seem to feel that the expiration of the payroll tax breaks will be the biggest single influence on US consumer spending, the reality is that the much larger issues, the ones that will influence long-term economic growth the most, have not yet been dealt with. The real work will come over the next two months, while lawmakers attempt to reconcile their positions on spending cuts and entitlement programs.

 

An Update on Last Minute Fiscal Cliff Negotiations

So, At The Final Hour, How Do Things Look?

Sunday, Dec. 30th, Republicans and Democrats again picked up negotiations on how to deal with the combination of automatic spending cuts and the expiration of Bush-era tax reductions at the new year. Senate Republican leader Mitch McConnell (R-KY) and Vice President Joe Biden took part in what they called “good” talks late into Sunday evening, a McConnell spokesman said. There is a good chance that a failure to reach agreement by the end of today, January 1, could push the US back into recession; higher taxes would rise for virtually every working American and across-the-board government spending cuts will kick in tomorrow (Tuesday the 1st). Analysts agree that failure to reach an agreement could significantly reduce consumer spending, leading to a certain fall off the ‘Fiscal Cliff‘.

Sunday’s negotiations centered on the main sticking points of the as-of-yet to be made deal; primarily discussions focused on income threshold for higher tax rates and inheritance taxes. The income threshold line- and definition of the ‘rich’ have been a major sticking point in negotiations thus far. Yesterday, President Obama blamed Republicans for the deadlock, saying their “overriding theme” was protecting tax breaks for the rich. In an effort to reach some level of middle ground, Democrats have reportedly offered to extend tax cuts for families with income levels up to $450,000 per year, which is a significant increase in the previous earnings threshold sought by Democrats, which would only include tax cuts for families earning under $250,000 per year.

In the event that no agreement is reached in today’s last minute House and Senate meeting, senators will be given the opportunity to vote on a so-called fallback plan proposed by President Obama. The plan would maintain tax cuts on earners under $250,000 and would extend unemployment benefits, but it fails to address the significant spending cuts. Odds are that even if a deal is reached, political infighting will likely continue early in 2013, as the deal will do little to address the original issue of reducing the deficit and the government debt limit.

Senate Republican Leader Mitch McConnell and Senate Majority Leader Harry Reid (D-NV) said that on Sunday negotiations were at a standstill, as both parties were still divided over the primary issues noted above. Late Sunday, however, Senate Republicans stated that they have dropped the Republican proposal to slow Social Security payments, the proposal had been hotly contested by Democrats as it would have led to lower benefits to pensioners and the disabled. That is a good sign, as both parties seem to be making concessions in order to create some progress.

Senator McConnell has said that “there is no single issue that remains an impossible sticking point,” but that the problem, or ‘sticking point’ appears to be “a willingness, an interest or courage to close the deal.” In reality, though, it is clear that Republicans, some of whom have taken a cult-like pledge to never raise taxes, believe the deficit is a direct result of excessive government spending and would like to see the tax threshold at the level Democrats have just now acquiesced to – around $450,000, and that increased revenue should be driven by economic growth and cuts to entitlement programs (focusing on social security) that states provide.

Bottom Line
The best of a bad situation won’t necessarily be a great solution, more of a ‘lesser of many bad solutions’ scenario. The most realistic compromise would draw the income line for tax hikes at around $450,000, and potentially preserve top tax rates on dividends and capital gains. The problem is, that even if Biden and McConnell agree, it isn’t guaranteed that Harry Reid would be on board, OR that it could get through the whole Senate OR that it could even get past the House GOP which rejected Boehner’s Plan B deal just last week.

There are numerous competing ideological absolutes at work here- taxing the rich (or not, and how to define the rich), cutting entitlement spending (or not), overturning budget sequestration (or not), and hiking the debt ceiling (you guessed it, or not) just to name the most prominent. With so many factors to work out, it is hard to imagine, or expect, that so much can get worked out within a time horizon that is now measured in hours.

The optimal compromise would likely be straightforward, and would be a bill that simply preserves the status quo for a while, creating a post-election cooling-off period long enough for negotiations to start anew on solid footing. That compromise, though, is improbable if only because the ideological issues are now instruments in a political blame game where a “tie” like the aforementioned outcome (which would serve as a bridge to further negotiations) may not even be a viable outcome for the parties involved. It seems that with no good solutions in sight, market volatility and economic uncertainty will continue to be issues until we either fall of the cliff or we come to a last minute bridge to extend negotiations and the increase the probability of political, and fiscal, resolution.