The Fiscal Cliff Explained
Have you heard about the fiscal cliff? If not, it's time for a quick explanation. It's big, it's important -- and you need to know about it.
The fiscal cliff is all about Jan. 1, 2013. If everything goes according to plan, policy changes taking effect that day will cause one of the biggest shocks to the economy since the financial crisis four years ago.
How can we be so sure? Because on Jan. 1, those policy changes will cause federal spending to fall -- and federal taxes to rise -- by a combined $607 billion in 2013 alone. The magnitude and abruptness of the changes gave rise to the name "fiscal cliff."
This isn't the result of new laws. The impending changes reflect how existing laws, some passed more than a decade ago, were designed to play out. Dozens of policy changes await, the big ones being:
1) Expiration of the Bush-era tax cuts
Congress and President Bush passed tax cuts in 2001 and 2003. The legislation was championed as tax reform but came with a distinct limitation: Rather than being made permanent, each round of cuts was designed to expire at the end of 2010 to conform to budget rules. In late 2010, Congress and President Obama extended the tax cuts for two years to avoid the looming expiration. Now both rounds are set to expire again on Jan. 1. If they do, federal taxes will increase by $221 billion next year, according to the Congressional Budget Office.
2) Expiration of the payroll tax cut
A one-year payroll tax cut was passed in December 2010, reducing taxes on the majority of working Americans by 2%. The cut was extended for an additional year last December, and expires again on -- you guessed it -- Jan. 1. It will raise taxes by $95 billion next year.
3) Budget-deal spending cuts
As part of last summer's deal to raise the debt ceiling, the Republicans and Democrats agreed to form a bipartisan "supercommittee" tasked with cutting $1.2 trillion in spending over a decade. If the committee failed that task, $1.2 trillion in automatic spending sequestration would take effect over nine years. The sequestration slashes indiscriminately across government programs in an attempt to prod legislators into action. But the supercommittee didn't reach a deal, so sequestration begins Jan. 1. The White House estimates it will reduce federal spending by $109 billion in 2013.
On top of all this, an expiration of extended unemployment benefits, a big cut to Medicare providers, and a laundry list of expiring tax deductions are also set to hit Jan. 1. Add it up, and we're talking policy changes equal to about 4% of the economy. This is quite literally one of the biggest alterations to how the federal government operates in modern history. And it starts in about 90 days.
Most economists agree that going over the fiscal cliff will tip us back into recession. The CBO predicts it would cause the economy to contract 0.5% in 2013, pushing the unemployment rate above 9%. That's particularly dangerous right now, as millions of Americans in precarious financial shape from the last recession have no room for error. It's not even a smart way to fix our debt problem. Falling back into recession and having higher unemployment means shrinking the taxpayer base, offsetting a big chunk of the deficit reduction.
Now, almost no one wants the fiscal cliff to happen, particularly in its entirety. There's something in it for everyone to hate: tax hikes if you're conservative-minded, spending cuts if you're liberal-minded. Both parties have voiced their desire to avoid the cliff by making a deal to extend current policies.
Odds are that will happen, probably with a last-minute deal hammered out like last summer's debt-ceiling deal. Goldman Sachs puts the odds of not striking a deal at just 35%. Moody's puts the odds of failure at 15%. Even if Jan. 1 rolls around without a deal, one could be made soon after, even retroactively. It's in neither party's interest to cause another recession.
Striking a deal will be messy. It will be loud, insulting, and at times terrifying. What's so dangerous about the fiscal cliff is that it'll happen if Congress does nothing -- and doing nothing is one thing Congress excels at!
What You Should Do About It
So what should investors be doing in the meantime? Probably nothing. If you're contemplating making big changes to your portfolio ahead of the fiscal cliff, stop. There's a good chance you're driven more by emotion than reason. If you were happy with your investment strategy three months ago, you should be happy with it today -- and three months from now. Smart investing is about long-term businesses, not short-term politics.
As for the possibility of getting hit with higher tax rates, it's hard to imagine a scenario in which taxes don't rise eventually, especially for higher-income Americans. You rarely want taxes to be the sole determinant of your investment decisions, but capital gains rates are near historic lows and could jump from a maximum 15% to 25% on Jan. 1. That could factor into your decision to part with an investment in the next few months, particularly if you were already planning to sell it.
Also, if you plan to convert a traditional retirement account to a Roth account, doing so when taxes are lower can lessen the tax hit. Many tax experts are also recommending that some clients "accelerate" income -- that is, bring income into this year that could be paid next year.
I'm still optimistic the fiscal cliff will be avoided, but count on months of threats, bickering, and nonsense. "You can always count on Americans to do the right thing," Winston Churchill said, "after they've tried everything else."
Authored by: By Robert Brokamp, a columnist and senior advisor for Fool.com - September 27, 2012
Comments(0)