The 'Cliff Notes' Version of the Fiscal Cliff

In case you have found all this talk about the upcoming “fiscal cliff” confusing, here is a brief  summary of how we got here and what it means to you.  These are important negotiations, with potentially serious financial implications for almost every taxpayer. 

With its back to the wall during last years debate over the debt ceiling, Congress came up with an interesting solution.  We will create a budget time bomb that will explode right after we all get reelected.  Both sides accepted this ridiculous compromise, figuring that with their own man in the White House they would get a better deal by waiting 12 months.  The time bomb was designed to make sure that the opposition would cave to the pressure and give the majority (they both assumed it would be themselves) whatever they wanted.   Unfortunately, there is no clear majority, with the Democrats in control of the White House, the Republicans in control of the house, and the Senate perpetually out of anyone’s control. 

What is the time bomb?  Tax rates on almost everyone will go up dramatically.  Tax rates on capital gains will go up, tax rates on dividends will go WAY up, adding insult to retired folk already injured by obscenely low interest rates!   The dreaded Alternative Minimum Tax will extend its reach far down into the middle class, potentially adding thousands of dollars to tax bills of ordinary families.  In a strange twist, the AMT change will even reach back into 2012, robbing many families of their expected tax refund come this spring.  Add to this the expiration of a temporary reduction in the payroll (FICA) taxes that increased your paychecks last year and the tax increases which will occur if we go “over the cliff” will be enough to really hurt almost all taxpayers.  Trust me, you do NOT want this to happen.  Unless you do not pay taxes at all, chances are you will be paying a whole lot more if Congress does not act. 

The other part of the time bomb is that federal spending will automatically be cut.  Not surgically, targeting programs of perhaps dubious merit, but across the board.  Including defense dollars.  The impacts will be wide ranging.  Don’t kid yourself into thinking the cuts will be absorbed by cutting waste!   This will hurt.

Theoretically, no one would want all of this to transpire, and a compromise should be reached.  But what happens if Congress does nothing?  That is a good question, because Congress is exceptionally good at doing nothing, making this a very possible outcome.  If Congress fails to act, a huge amount of money will be pulled out of the economy.  Not all at once on Jan 1, but gradually throughout the year.  If the situation is not rectified quickly, the result of so much money coming out of the economy so quickly (and not being spent on goods and services) will almost certainly result in another recession.  More job losses, lower stock prices, falling house prices...  Thus the phrase which describes the predicament we face as “the fiscal cliff”.

Why is it so hard to reach agreement?  The Democrats are insisting that tax rates go up on families with income over $250,000 from a top rate of 35% to a top rate of 39%.  They argue that new revenues are needed to solve the governments debt problems.  The Republicans are split, either wanting no tax increases at all, or accepting the inevitability of increases, but preferring to increase revenues by eliminating deductions for the wealthy.  The Republicans insist that the bigger problem regarding our long term financial solvency is entitlement spending which is scheduled to explode with retirement of the baby boom generation, and insist that reforms to improve long term solvency of Social Security and (more importantly) Medicare be part of any deal.  The Democrats (sensitive to the political power of older folks) would prefer to ignore entitlement reform for now, or perhaps make token changes. 

It seems that it would be very easy for rational sides to reach compromise.  However, compromise is a dirty word in politics today.  There are some on both sides who might prefer to see the country go “off the cliff”.  Democrats figure they can blame it on Republicans (they insisted on cutting your Medicare and protecting the rich) and Republicans running in districts with strong anti tax majorities, will claim to be standing firmly on anti tax principles (even though the result of going off the cliff is higher taxes for everyone). 

The irony is that even with all this rancor, the size of the proposed changes will barely make a dent in the deficit.  The amount of debt as a share of the overall economy will continue to rise.  So here we sit.  At the mercy of our elected officials and their political gamesmanship.  Anybody have a parachute?