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Without new legislation, at the end of 2012, major changes are going to occur in our financial markets and economy due to the “fiscal cliff.”  According to the Congressional Budget Office, this would cut the budget deficit from 7.3% of Gross Domestic Product (GDP) to 4% in 2013.  But even this understates the extent of the fiscal cliff since fiscal year 2013 includes three months before these changes take effect (fiscal 2012 ends at the end of this month).  On a calendar year basis, the projected drop in the deficit is closer to 3% of GDP.   This is too much too fast.

Before going any further, the basic math behind the federal budget needs to be understood.

First, the deficit is the gap between government spending and revenues in any one fiscal year.  Fiscal years run from October 1 of the prior year to September 30 of the current year and, as an approximation, the debt grows by the amount of the deficit each year.

Second, in measuring the impact of deficits and debts, we look at these numbers relative to GDP which is the overall output of goods and services in the economy.  The key issue, when it comes to fiscal sustainability, is the size of debt and deficits relative to the overall economy (or GDP).  

Third, in measuring the total debt, we look at what is known as “debt held by the public,” currently $11.2 trillion, rather than “total public debt subject to limit,” which currently amounts to $15.9 trillion.  “Debt held by the public” excludes money the federal government owes to its own trust funds, most notably, the Social Security trust fund.  This measure is the focus of most debt projections and is a better measure to use in assessing both the sustainability of debt and its impact on global financial markets.

From the mid-1980s to the year 2000, the fiscal situation improved substantially with only one recession, a strong stock market and the impact of the end of the Cold War on defense spending.  By 2000, the federal budget was in surplus and the debt/GDP ratio was falling rapidly.

Since then, America has experienced a series of shocks and slumps.  Two wars, two recessions, and two huge bear markets in stocks led to a surge in the deficit, as did attempts by both the Bush and the Obama administrations to “stimulate” the economy through tax cuts and increased government spending.  By fiscal 2009, the deficit had climbed to $1.416 trillion or 10.1% of GDP, with federal debt rising sharply.  

Over the last three years, the deficit has retreated somewhat, with the CBO estimating a deficit of $1.128 trillion, or 7.3% of GDP for the current fiscal year.  While this does represent some progress, estimates project the deficit would need to fall to below 4% of GDP in order for the debt to grow less quickly than GDP, thus stabilizing the debt/GDP ratio, albeit at a high level.

Using the rules of the sequestration, we are on our way, rather abruptly I might add, to get to that 4% in a hurry.  Under current law, as of December 31, 2012:

•    All the “Bush Tax Cuts” will expire.  This would, among other things, boost the top tax rate on ordinary income from 35% to 39.6%, increase the tax on dividends from 15% to 39.6%, increase the tax on long-term capital gains from 15% to 20%, and increase the estate tax rate from 35% to 55%, with the exemption amount falling from more than $5 million to more than $1 million.

•    The 2% payroll tax cut will expire.

•    The extra .9% Medicare tax for upper-income households and the broadening of the Medicare tax base to include investment income for the same households will take effect.

•    The extended unemployment benefit program will expire.

•    The two rounds of discretionary spending cuts agreed to in August 2011 will take effect, first adhering to formal caps on discretionary spending over the next decade, and then further reducing this spending due to the failure of the so-called “super-committee” to agree on an alternative deficit reduction plan.

On paper, if all of this were implemented, it could reduce the deficit substantially.  In practice, it would likely push the economy into a new recession as consumers reduced spending in reaction to lower after-tax income, the stock market fell in response to higher dividend and capital gains taxes, and reduced government spending increased layoffs throughout the economy.

This election is extremely important to the economic conditions of the economy.  Both parties come to the table with different policy positions.  In general, the Democrats will increase taxes for upper-income households and the Republicans will focus on spending cuts.  

Given that going too fast is not desirable, the best solution is likely one in which the deficit comes down more slowly in 2013.  To do this, we might:

•    Extend the Bush tax cuts in full for 2013.  From 2014 they are extended only for households earning less than $250,000 per year (combined with an Alternative Minimum tax “fix”).  The top dividend tax and capital gains tax rates rise from 15% to 20% in 2014.

•    Phase down the payroll tax cut to a 1% cut in 2013 and eliminate in 2014 in order to mitigate the fiscal drag from the partial expiration of the Bush tax cuts.

•    Extended unemployment benefits expire on schedule

•    Allow for the higher Medicare taxes to pay for President Obama’s health care plan to take effect

•    Only the first round of spending cuts agreed to last fall get implemented. The second round does not take effect.

Under this scenario, the budget deficit is predicted to fall moderately from 7.3% of GDP this fiscal year to 6.5% next fiscal year, 5.5% in fiscal 2014, and 4.5% in fiscal 2015.  The deficit then would gradually fall from 7.0% of GDP to 4.2% of GDP after 2015.  The stock market would be negatively impacted by higher taxes.  However, by fostering economic growth while gradually reducing the deficit, this scenario could enhance investor confidence.  It would likely be a negative for Treasury bonds as more responsible fiscal policies could set the stage for a gradual tightening by the Federal Reserve.  Municipal bonds could potentially fare better than Treasuries because of reduced credit risk and the enhanced value of tax exemption for upper income households.

I think it is safe to say, regardless of the outcome of this election, that the priority for Congress needs to be to fix our broken fiscal policies.  The Federal budget is in chronic need of both tax and entitlement reform.  In the long run, the fiscal problem facing the US requires budget reform so that our system of government can once again be a key competitive advantage rather than a growing disadvantage of the US economy.  

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Comment Preferences

  •  property (0+ / 0-)

    we should go over the cliff and restructure around the principle that ownership of private property is a right guaranteed by the Constitution, but does not exist in the State of Nature.

    the taxpayers of the usa are subsidizing the outsourcing of corporate assets by PAYING FOR THEIR SECURITY IN THE FORM OF OUR MILITARY EMPIRE.  That subsidy should end.

    we need a green new deal now, or climate change will render all other political goals irrelevant.

    The wealth produced by this society is not produced by individuals, contrary to popular myth.  The allocation of wealth is something determined by legislation in a democratic republic system.  It's not determined by "entitlement," "class," "need," or "productivity."  These laws need to be reexamined and rewritten to maximize the benefits to the united states of america, not to a small percentage of our citizenry.

    reoganizing society around cooperation and equality will go a long way toward ameliorating the effects of the cliff and averting  climatic disaster in the short term.

    "... all things for which you pray and ask, believe that you have received them, and they will be granted you." --Mark 11:24

    by november3rd on Wed Sep 19, 2012 at 12:50:07 PM PDT

  •  Just one more idea, for now. (1+ / 0-)
    Recommended by:
    BayAreaKen

    Increase the Minimum Wage to $9.00 per hour immediately and $10.00 per hour in 2014.  

    Well, I've got a few more seconds.  0.30% Financial Transaction Tax on the value of the sale, paid half each by Seller and Buyer.  Remove the wage limit on SS Tax.

    I've got no time for ideas on how reduce costs, but I'll try to get back later.

    "Never let up. Crush bigotry and greed."

    by LouisMartin on Wed Sep 19, 2012 at 03:00:03 PM PDT

  •  Why aren't we talking up the People's Budget? (0+ / 0-)

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