Is The US Headed For A Fiscal Cliff in 2013?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
March 27, 2012

IN THIS ISSUE:

1. U.S. Cruises Toward a 2013 Fiscal Cliff

2. Automatic Spending Cuts Begin on January 15

3. Could Tax Hikes & Spending Cuts Spark A Recession?

4. Another Debt Ceiling Fight This Year?

5. Supreme Court Tackles Obamacare Mandate

Introduction

There are two prevailing views among economists and forecasters these days when it comes to our soaring national debt, which is now over $15 trillion. One view, held largely by conservatives led by Wisconsin Representative Paul Ryan, is that we must cut government spending significantly, and the painful process must begin sooner rather than later.

The other view, largely held by progressives, is that if we cut federal spending significantly, it will definitely slow the economy and very likely lead to a recession. Their answer, of course, is to continue spending and raise taxes on the wealthy to reduce the deficits.

The reality is, however, that both sides are on track to swallow a bitter pill beginning on January 1, 2013. Under current law, the Bush tax cuts expire at the end of this year – for everyone. President Obama only wants the Bush tax cuts to expire for those individuals making over $200,000 a year and joint filers making over $250,000. Chances are probably good that he’ll get his way, and only the so-called “rich” (as defined above) will see the tax increases. But Congress has to act to extend any of the Bush tax cuts.

On the federal spending side, you probably remember the 2011 Budget Control Act which includes “sequestration,” or across-the-board spending cuts, to all federal departments if Congress can’t design and pass a budget that more specifically outlines spending cuts totaling $1.2 trillion over the next 10 years.

It’s becoming more and more obvious that the Senate is not going to pass a budget this year, for the third year in a row. The latest budget submitted by Paul Ryan in the House has no chance of passage in the Senate. So the sequestration is set to kick in on January 15, 2013 and alarm bells are increasingly being sounded by Democrats and Republicans alike.

The question is, what will the effects be on the economy due to the combination of tax hikes and spending cuts starting next year? How bad will it be? We’ll discuss all of this as we go along.

U.S. Cruises Toward a 2013 Fiscal Cliff

Headline: As tax cuts expire and spending falls, the economy could be hit with a 3.5% decline in gross domestic product that could throw us right back into a recession next year.

Income taxes are set to automatically go up next year for everyone if the Bush tax cuts expire at the end of this year. President Obama says he wants the Bush tax cuts to expire only for those individuals making over $200,000 a year and families making over $250,000. But without congressional action, all of the Bush tax cuts will expire.

If Congress does take action, and gives Obama what he wants, those making over $200,000/$250,000 will see their tax rates go up as high as $39.6%. Plus the first ObamaCare tax of 3.8% on investment income for these same “rich” people also kicks in starting next year. For those who make over $200K/$250K, and all of their income is from their investments, their tax rate will go as high as 43.4%!

Plus, President Obama wants a new law that will require anyone making $1 million or more to pay a minimum income tax of at least 30% (more on this below). Many of these people are key job creators. Obama also wants dividends taxed as ordinary income (39.6% for many), up from 15% today. He also wants the capital gains tax rate increased from 15% to 20%.

And there are other changes scheduled for the end of this year that qualify as tax hikes. The 2% payroll tax holiday expires at the end of this year unless it is extended again. At some point, presumably on January 1, the repeated extension of unemployment benefits has to be reduced, perhaps significantly. A reduction in benefits will have much the same effect as a tax hike.

Again, the question is, how bad will this be for the economy? But there’s more.

Automatic Spending Cuts Begin on January 15

As part of the deal ending the acrimonious debate over raising the national debt ceiling last August, the president and Congress created the bipartisan Joint Select Committee on Deficit Reduction, commonly known as the “Super Committee." It was charged with finding ways to trim at least $1.5 trillion from projected deficits over 10 years.

Mindful that the committee might not prove to be that super, Congress stipulated that formulaic spending cuts of $1.2 trillion would kick in automatically if the committee failed. To make this threat even more frightening, Congress aimed half the $1.2 trillion in spending cuts straight at the Defense Department. The Committee failed anyway, and those automatic cuts are headed our way starting January 15 next year.

Many in Washington are starting to get very nervous that Congress may not be able to figure out a way to wriggle out of these mandatory cuts before the end of the year. There is a growing sense that Congress is not going to pass anything major until after the election.

In the absence of progress between now and Election Day, the lame duck Congress will have less than eight weeks left – including Sundays, Thanksgiving, Christmas and New Year’s Eve – to address the tax hikes and automatic spending cuts before the end of this year. No wonder people are getting nervous!

Could Tax Hikes & Spending Cuts Spark A Recession?

There is no doubt that a combination of tax hikes, the end of the payroll tax holiday and curtailment of unemployment benefits, along with the automatic spending cuts, will be a drag on the economy. The question is how much of a drag?

It is widely agreed that the FY2013 federal budget is going to have the biggest impact of any budget in decades. That’s because the fiscal headwind comprised of both tax increases and spending cuts under current policy totals more than $500 billion, or 3.5% of GDP, so say the Congressional Budget Office and the White House’s Office of Management & Budget. Simply put, that’s a huge headwind!

Alan Blinder, an economics professor at Princeton University and former Vice-Chairman of the Federal Reserve, has been studying this matter intently. With regard to the 3.5% contraction in GDP, he cautions:

“That's a big fiscal hit, roughly as big as what a number of European countries are trying to do right now, though with limited success and with notable collateral damage to their economies. An abrupt fiscal contraction of 3.5% of GDP would be a disaster for the United States, highly likely to stifle the recovery.”

Martin Feldstein is a well-known economist I have read for many years. He is currently an economics professor at Harvard, is the former president of the National Bureau of Economic Research and was the chief economic advisor to President Ronald Reagan. In a recent article in The Financial Times, Feldstein focused on the negative effects of the upcoming tax hikes on the US economy:

"The Congressional Budget Office predicts that, under current law, the revenue of the federal government will rise from $2.4 trillion in the current fiscal year, which ends in September, to $2.9 trillion in the following fiscal year. That increase of $512 billion is equivalent to 2.9% of GDP, bringing federal revenue as a share of GDP from 15.8% this year to 18.7% next year.

The higher revenue would reflect an increase in personal tax rates, higher payroll taxes, as well as higher taxes on dividends, capital gains and corporate incomes. [Federal] Revenue would continue to rise in future years – as a share of GDP it would increase to 19.8% in 2014 and would stay above 20% for the remainder of the decade.

A sustained tax increase of that magnitude would push the U.S. into a new and deep recession next year. So, it is important to recognize that legislation is required to prevent such a tax rise.”
[Emphasis added.]

Feldstein believes getting that legislation passed will be difficult. He adds:

“Mr. Obama has said he wants to keep the high rates for upper income taxpayers and to raise total taxes on corporations and other businesses. The Republicans in Congress and the Republican presidential candidates have indicated they want to avoid all of the increases that are specified in the current law and to start a process of tax reform. So the 2013 tax rates will depend on the outcome of the presidential elections in November.”

I think Feldstein is correct that it all hinges on the election. If President Obama is re-elected, it will be next to impossible for the Republicans to roll back the tax increases that are already written into the law. Even if the Republicans gain a majority in the Senate and manage to hold onto the House, it will still be difficult since Obama could veto such a move.

Another Debt Ceiling Fight This Year

We all remember the bitter debt ceiling debate in Washington last summer, the one that resulted in the first-ever downgrade of the US credit rating. Well, another showdown could be in the offing sooner than planned.

The deal cut last August to end the debt ceiling standoff provided for a $2.1 trillion increase in the country’s legal borrowing limit to $16.394 trillion. At the time, it was estimated that such an increase could carry the Treasury Department safely beyond the contentious presidential election season and into early 2013.

But now that Congress has extended the payroll tax cut, emergency unemployment benefits and the so-called Medicare “doc fix” – only some of which was paid for – there is a greater chance that US borrowing could reach the debt ceiling sooner.

Treasury Secretary Geithner recently told lawmakers that even with the recent passage of the payroll tax bill – which will add an estimated $101 billion to the deficit in fiscal year 2012 – he doesn't expect the debt limit to be reached “until quite late in the year.”

He presumably means sometime after the November 6 elections, but that remains to be seen. Even if we manage not to hit the ceiling until a few days after the election – which I’m sure Geithner will do everything in his power to make happen – the looming battle will be an election issue that no politicians wanted to have to deal with until next year.

More importantly, if we hit the debt ceiling in November or December, that will be smack dab in the middle of the fight over tax hikes and spending cuts discussed above.

Obama’s “Millionaire Tax” aka the “Buffett Rule”

On January 24, President Obama said that America needs a new tax system, but one that is aimed only at people who make $1 million or more a year. Obama said:

"Tax reform should follow the Buffett Rule. If you make more than $1 million a year, you should not pay less than 30 percent in taxes. And my Republican friend Tom Coburn is right: Washington should stop subsidizing millionaires. In fact, if you're earning a million dollars a year, you shouldn't get special tax subsidies or deductions."

Basically, the President is proposing a new "Super Alternative Minimum Tax" of 30% for anyone making over $1 million. So if your income is above $1 million, you have to pay at least 30% of your income in taxes, even if that income came from capital gains or dividends, which are currently taxed at 15%.

Like the regular Alternative Minimum Tax – which was enacted in 1969 to prevent a handful of millionaires from paying less on their taxes but now impacts over 3 million Americans – this new Super AMT would reduce any deductions that might reduce your effective tax rate below 30%.

The details on how this new tax increase will be implemented, assuming it is passed into law, are not yet clear. I may revisit this issue when we know more about the details, again if it is passed.

You might intuitively assume that anyone making a million dollars or more a year would automatically be in the highest income tax bracket, currently 35% but on its way to 39.6% or more if Obama gets his way. But there are many millionaires who do pay less than 30% in income taxes because most of their income is from capital gains and/or dividends that are taxed at 15%.

The widely respected Tax Foundation estimates that the Buffett Rule would be the equivalent of raising the top marginal rate from 35% to 44% for those earning over $1 million per year. The Tax Foundation believes that the average effective tax rate for millionaires is around 25% today (although I’ve seen higher estimates elsewhere).

Using the Tax Foundation’s figures, based on the current amount of deductions millionaires take, in order to raise their effective tax rate up to 30%, you would have to raise the top marginal tax rate to 44%. On a static basis, they estimate that this policy would raise only about $40 billion a year – assuming that taxpayers don't change their behavior – which they will. Compared to a $1.1 trillion deficit next year $40 billion is a drop in the bucket!

The Obama administration knows this, but the President continues to push for the Buffett Rule only because he thinks it’s “fair.” If he’s re-elected, the Buffett Rule is almost a certainty.

Supreme Court Tackles Obamacare Mandate

The Supreme Court began deliberations yesterday on the Obamacare mandate that all Americans would be forced to buy health insurance. The High Court will debate whether or not the mandate is constitutional. While the arguments will end tomorrow, a final decision on the matter is not expected until late June at the earliest.

This topic was the subject of my blog on Friday, so I won’t repeat it again today. But you can read it by CLICKING HERE.

Here’s another good argument on the constitutionality, or unconstitutionality, of the Obamacare mandate from National Review that just came out yesterday:

http://www.nationalreview.com/articles/294370/constitution-vs-obamacare-editors

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Gary D. Halbert

 

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