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Likely Fiscal Cliff Outcomes: Handicapping the Fiscal Cliff

December 11, 2012
Investing
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If we go over the Fiscal Cliff, a lot of things could happen – $607 billion of policy changes leading to deficit reduction, to be precise.

While a lot of them most likely won’t happen, others inevitably will – here is NerdWallet’s take on what is at stake, the political landscape, and some probable likely outcomes based on the numbers.

See also: Infographic – What Is the Fiscal Cliff and How Will It Impact the Economy?

The Politics Behind The Fiscal Cliff

The Titans are fighting on Mount Olympus; Congress and the President are hammering out an agreement on the future course of the Republic. All agree that borrowing 40 cents out of every dollar the government spends won’t work. And the Federal Reserve can’t goose the money supply via qualitative easing measures forever.

But power is divided: The Democrats (and their constituencies) have the White House and the Senate. The Republicans (and their constituencies) have the House of Representatives, from whence all revenue bills must originate. Any side can block any ideas from any other. But if everybody blocks everything, and they can’t reach a deal, we’re looking at a nasty recession in 2013, according to the Congressional Budget Office.  Figure a 2.9 percent fall in GDP in the first six months, a fall of 0.5 percent across the full year, unemployment back up to 9 percent plus, dogs and cats living together, and mass hysteria.

Nobody wants that. Well, unless they think they can pin the blame on the other party. But everyone playing that game is an incumbent, and risks getting swept out of town in the midterms if the mood during the 2014 elections becomes anti-incumbent, rather than anti-obstructionist.

Further, the whole point of the Budget Control Act of 2011 was to cause a deficit reduction. But if the CBO is right and there’s a 2.9 percent recession early in the year (Moody’s pegs it at 2.8 percent with 9.2 percent unemployment at the end of the year), then that alone will cause a worsening of the deficit situation. And cause a lot of Congressmen to be unemployed after the midterms.

Likely Deals Come 2013

So a deal they will make.  Politics, of course, is the art of the possible. So what kinds of deals are likely?

  • There will likely be a marginal income tax increase on wealthy Americans.

Democrats will not walk away without a victory on this point. The GOP will have to budge. The floor will be higher than the $200,000 per year asked for by the Obama Administration. The $200k to $250 k floor for the tax increase will mobilize too many small business owners and power couples. Yes, many republicans signed a “pledge” to oppose any tax increases. But the risk of being blamed for obstructionism, in the same way Newt Gingrich was blamed for obstructionism in Clinton’s 2nd term, will eventually be viewed as a greater danger than anger from affected constituents. Obama possesses the bully pulpit, and both sides can declare victory with a tax hike effective on those with incomes over $500,000 or so. It is possible that the tax increase will be disguised as an elimination of loopholes. Don’t fall for it.

  • President Obama will likely not get his proposed cap on charitable giving deductions.

Enough said.

  • The military will likely be gutted – in a bad way.

The military industrial complex has powerful friends in Congress, and we will retain stupid bases out of habit, and we will continue to manufacture weapons suited more for the last war than the next. However, training budgets and spare parts budgets needed to maintain our existing fleet of vehicles, non-glamorous weapons and otherwise prevent the force form becoming a paper tiger have no powerful advocates. We always forget the lessons of Corrigedor and Task Force Smith. ‘Twas ever thus.

  • We will also likely continue to invest large amounts of money in “green initiatives.”

 Like bio fuels for Navy ships that costs 26 dollars per gallon, for example, rather than develop domestic energy sources.

  • The Bush Tax Cut rates will likely be extended for those making less than $250,000 per year.

Yes, Democrats demonized them for a decade saying the benefited the wealthy at the expense of the middle class. Now even Democrats are signing onto an extension. Apparently they benefitted the middle class after all. Low hanging fruit. They will be extended.

  • The home mortgage interest deduction’s days are likely numbered.

At least as currently structured. It may well survive the year, but will eventually be heavily modified or scrapped. It’s inefficient, it doesn’t do much to expand home ownership rates, and it costs $53,590 per homeowner it creates. Yes, it does have a number of powerful lobbies behind it. But there are other, more effective ways to accomplish the same policy results. Look for a reduction in the amount of principal that qualifies for the interest deduction – from $1 million to something closer to $500,000. This will be a good thing. Renters should not have to subsidize homeowners any more than they already do, and homeowners continue to benefit from the $250,000 exemption on capital gains. That’s half a million for married couples. Meanwhile, if you rent, and buy assets to sell in retirement, you get nailed for the full capital gains monty. This doesn’t seem fair. Yes, 68 percent of Americans oppose the repeal of the home mortgage interest deduction. But we all saw the grand Stanford experiment that was the 2012 presidential election: A plurality of Americans will happily support throwing anyone they perceive as wealthier than they are under the bus.

  • The top long term gains rate is likely going up to 20 percent.

Embrace the (you guessed it – likely) reality.

  • The favorable tax treatment of dividend income?

It’s likely gone for a while. Americans are not sympathetic to the double taxation plight of C corporation stockholders. True, they don’t understand it. But they aren’t sympathetic to it, anyway.

  • The alternative minimum tax fix will likely be passed, temporarily.

Failure to pass the AMT fix would result in the number of taxpayers subject to the alternative minimum tax to increase from 4 million to 31 million. That means torches and pitchforks in the mid-terms – especially in wealthier districts.

  • The ‘doc fix’ will likely be extended.

Again, this is a visceral torch and pitchfork issue. Neither side wants to address Medicare costs honestly. But both want the issue to go away for a little longer. Extended for the worst of reasons.

  • The payroll tax holiday will likely be terminated.

Yes, it will immediately cost every working stiff in America 2 percent of his purchasing power, right off the bat. Imagine a 2 percent fall in retail sales. Ugh. But the Social Security Administration cannot withstand an assault on its actuarial basis indefinitely. The benefits cost what they cost, and even politicians know they can’t get around that with smoke and mirrors. Workers will have 6.2 percent of their paychecks withheld instead of just 4.2 percent.

  • Affordable Care Act Taxes will likely go through.

That means an additional 3.9 percent capital gains tax, on top of the new 20 percent tax rates. There will be another 0.9 percent withholding from higher income Americans, too, to pay for ObamaCare costs. The Republicans would love to repeal them, but it’s already law, and they don’t have the votes to stop it. Dems will not want to surrender the symbolic point on their signature piece of legislation.

That’s the tax side of the equation. That still leaves a substantial series of proposed spending cuts. But chances are that if the two sides can come to a compromise on tax policy, they will declare victory and sidestep at least the more onerous sequestration provisions.

What Are Analysts Saying, and How Would Markets Respond?

Moody’s is handicapping this halfway solution at a 55 percent probability – by far the most likely of the three scenarios, and that sounds right. PIMCO is also looking for a solution of half-measures.  It’s a fiscal bump, to be sure, but not the cliff that some fear.

The stock market thinks this is bad news, too. That’s why equities fell by so much in the days immediately following the election. They understand the basic concept of tax capitalization. Tax an asset more, and it’s worth less on the market. Share prices were adjusting themselves towards their new lower after-tax valuation in a double-taxation environment. Yes, there are people who will try to blame the post-election stock market declines on Greece.  Really though, Greece was just as much of a basket case before the election as afterward. And yet stocks held firm until Obama won and hopes of the Republicans retaking the Senate were dashed.

  • See also: Infographic – What Is the Fiscal Cliff and How Will It Impact the Economy?

Disclaimer: The views and recommendations in this piece are held by the individual contributor and do not reflect the opinions of NerdWallet