In August 2011, after months of wrangling over the deficit ceiling, political leaders from both parties decided to postpone solving our fiscal problems until January 2013.
To resolve the impasse over the budget ceiling, Congress passed the Budget Control Act of 2011. The law would decrease the deficit by $1.2 trillion over the next 10 years. The deficit reduction would be achieved through tax increases and across-the-board cuts (known as “sequestrations”), split evenly between defense and domestic spending. The ordinary income-tax rate for top earners would increase to 39.6 percent from 35 percent. The tax on dividend income would be equivalent to your ordinary income tax rate. The rate for long-term capital gains would increase from 15 percent to 20 percent.
The 2 percent reduction in the payroll tax would expire. The alternative minimum tax would apply to millions more of our citizens.
In addition, a new 3.8 percent Medicare-contribution tax will be imposed in 2013 under the Affordable Care Act for individuals whose income exceeds $200,000, $250,000 for joint filers.
“Fiscal cliff” is the popular shorthand term used to describe these measures and their effects on the economy.
On Aug. 22, the Congressional Budget Office warned that the U.S. will sink into a recession if Congress fails to postpone the $500 billion of tax increases and budget cuts scheduled to start Jan. 1. The CBO warned that our upcoming fiscal standoff could cause more serious damage than previously forecast. The CBO foresees a contraction of 2.9 percent in gross domestic product and could push unemployment up to 9.1 percent by the end of 2013.
The CBO’s August warnings contrast sharply with its earlier upbeat assessments. In May, the CBO said it expected the economy to grow 0.5 percent in 2013, despite the fiscal cliff.
Even if Congress delays implementing the fiscal cliff for a year in order to give itself even more time to negotiate a solution, the CBO believes the economy will be weaker next year than it previously thought. The CBO now projects anemic 1.7 percent growth in 2013. The weak state of our economy is even renewing predictions that the Federal Reserve will engage in a new round of quantitative easing.
Surprisingly, the stock market is shrugging off the bad news. Despite the CBO warning and the Fed’s concerns, the American stock market has returned to near record territory
Why? Most investors believe the fiscal cliff will be avoided in a lame-duck session of Congress that starts after our November elections.
David Kostin, Goldman Sachs Group’s chief U.S. equity strategist, is pessimistic over the short term, forecasting that the S&P might drop 11 percent from current levels. On Aug. 16, Kostin said in a radio interview on “Bloomberg Surveillance” why he was worried about a market downdraft: “You saw the experience last year. In 10 days, the market fell 10 percent around the whole issue (the political infighting) of the debt ceiling and negotiations.”
Other analysts disagree with Kostin. They doubt Congress will allow tax increases and spending cuts to undermine an already weak economy. Bill Stone, chief investment strategist with PNC Wealth Management, said in a CNBC piece by executive news editor Patti Domm that, “I think the consensus is we don’t hit the whole fiscal cliff, and in that respect it is priced in.”
Given the CBO warning, we might want to recall Warren Buffett’s admonition to “be fearful when others are greedy and greedy when others are fearful.”
We are at a fork in the road. We either face continued trillion-dollar deficits or go over the fiscal cliff. The S&P has almost doubled since the lows of 2009.
Taking some chips off the table seems prudent.
Originally published in the Sarasota Herald-Tribune
