The fiscal cliff in-depth

Talk of the impending fiscal cliff has been dominating the news cycle, and for good reasons.

First let me get this disclaimer out of the way – I am an analyst, not a CPA, lawyer, or lobbyist. I am an interested onlooker to the dysfunction in Washington. So keep that in mind as you read this. Also this is being written before Christmas, so a lot can happen as negotiations get closer to the deadline.

This budget brinkmanship will have an effect on the economy, Texas included. Try to imagine the effect of not receiving Federal funds will have on all states. Texas received about $55.1 billion during the 2010-2011 biennium money from the federal government. San Antonio, Austin, and Killeen would be greatly affected.

“Fiscal cliff” is the popular shorthand term used to describe the conundrum that the US government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

There are two major factors when combined that produce the ‘fiscal cliff’. The first factor is budget cuts. Back in August of 2011, Obama and Congress, under pressure from the ‘Tea Party’ and fiscal conservatives signed in to law the Budget Control Act of 2011. This was designed to cut the budget deficit in half by cutting $1.2 trillion across the board from the federal budget over ten years. This kicks in December 31st, 2012. According to many analysts, over 1,000 government programs – including the defense budget and Medicare – are in line for ‘deep, automatic cuts.’

The second factor is tax hikes. A host of tax breaks, including the Bush tax cuts which were signed in 2001 and extended by Obama for two years in 2010, are set to expire.

They include payroll tax cuts (workers will face a 2% tax increase if these expire) and changes to the Alternative Minimum Tax (which would in turn be a larger tax for many consumers). The pending expiration of estate and gift tax cuts has left many people of means scrambling to use what has been billed as a once-in-a-lifetime way to give tremendous amounts of money to heirs tax-free before death. The child tax credit would include lowering the amount of the child tax credit from $1,000 per child to $500 per child, narrowing the tax bracket for married couples causing them to pay more, and reducing itemized deductions and personal exemptions. These all expire at midnight, December 31st 2012. In addition, the beginning of taxes related to President Obama’s health care law will also go into effect.

Understand that we need deficit reduction. But cutting $700 billion – all at once and across the board – out of the Federal budget sets us up for another recession and rising unemployment. Those cuts are equal to about four percent of GDP, which is, according to the Congressional Budget Office, more than enough to throw us into a recession.

Economists and analysts disagree on exactly how quickly the recession would begin. That’s why the “cliff” metaphor is inappropriate. If financial markets freak out, it might happen very quickly, proving the “cliff” imagery correct. But it might happen gradually, affirming those who’ve argued it’s a “slope.”

Either way, both parties agree it shouldn’t happen at all. But that’s the rub. The reason that the fiscal cliff could push us into another recession in 2013 is because it enacts too much deficit reduction upfront, not too little. And yet, deficit reduction is something that most members of Congress and their voters support, at least in the abstract. So both sides want to replace the fiscal cliff with…something. The question is, with what? And can they come to agreement?

It’s important to recognize that this austerity crisis is a collision between deficit reduction and stimulus. The good news is that if you look at the various components of the fiscal cliff separately, you’ll see that the parts that do the most for deficit reduction do the least for the recovery, and vice versa. This suggests the possibility of “a la carte” approach to the fiscal cliff, in which we extend the most stimulative policies and wave goodbye to the most costly policies

What is the fiscal cliff in one sentence?

Too much austerity, much too quickly – like quitting the spending habit cold turkey. Not many addicts can quit cold turkey without harm from withdrawal.

If it’s not a cliff, what is it?

The term “fiscal cliff” comes from testimony Fed Chairman Ben Bernanke delivered before Congress earlier this year. A better name would be “austerity crisis.” That solves two problems. First, the danger the economy faces is too much austerity too quickly, so swapping the term “fiscal” for the word “austerity” actually better reflects the situation. Second, while we don’t know if it’ll be a cliff or a slope, we do know that it will, if permitted to go on for long enough, be a “crisis.” Thus, the “austerity crisis.” And yes if there is uncertainty, then job creation slows.

There are four types of spending cuts that take effect next year.

The sequester
The sequester was mandated by the Budget Control Act of 2011, better known as the debt ceiling compromise. This institutes a 2 percent cut in physician and other providers’ Medicare payments, and a 7.6 to 9.6 percent across the board cut in all discretionary spending, except programs for low-income Americans. The cuts are evenly divided between defense and nondefense programs, with most analysts predicting a crippling effect on all affected departments, agencies, and industries.

The sequester can be averted by repealing the portion of the BCA mandating the cuts, which amount to about $110 billion next year.

Budget caps
Also in the Budget Control Act, these set a firm limit on discretionary spending within which policymakers must operate. They are set to reduce spending by $78 billion next year.

Doc fix
The Medicare Sustainable Growth Rate (SGR) is a method currently used by the Centers for Medicare and Medicaid Services (CMS) in the United States to control spending by Medicare on physician services. This policy, passed every Congress for 15 years now but lapsing at the end of 2012, reverses temporary cuts that Congress passed, and former President Bill Clinton signed, as a deficit reduction measure in 1997. The cuts, known as the “Sustainable Growth Rate” or SGR, require that growth in provider payments not exceed growth in Gross Domestic Product. If the doc fix is not extended, physician payments would fall by an estimated 30%, dwarfing the cuts enacting as part of the debt ceiling deal. That would cut spending by $14 billion next year.

Unemployment insurance
Unemployment insurance was expanded following the recession, and due to the slow recovery this expansion has been regularly extended. Doing so again would cost $39 billion.

Debt ceiling
When exactly the debt ceiling is next reached depends on how much the government actually spends and taxes in the coming months. But most analysts think the next debt-ceiling increase will come due around February. The Bipartisan Policy Center estimates we’ll have to raise the debt limit by anywhere between $730 billion and $1.25 trillion to avoid the debt ceiling for all of 2013 (depending on whether the Dec. 31 fiscal changes measures are enacted or not) and between $1.3 trillion and $2.2 trillion in 2014.

A fiscal cliff deal is likely to include an increase to the debt limit. But in a world without a deal, an ongoing austerity crisis could be worsened by a default. The economic consequences of that are suggested to be along the lines of the financial crisis of what we saw in 2008.

What happens if we go over?

Analysts expect that the austerity crisis will weaken the economic recovery and quite possibly plunge the United States back into a recession. The CBO predicts that the US economy will shrink by 0.5 percent in 2013, and unemployment will spike up to 9.1 percent from its current level of 7.9 percent, if no fix is passed. However, if all policies, including the payroll tax cut, are extended, the economy will grow 2.4 percent.

Deficit reduction
If the austerity crisis hits in full, both short and medium-term deficit problems in the US would vanish. The CBO projects that under current law, debt held by the public will fall to only 58 percent of GDP by 2022, below the 60 percent mark that many economists warn against exceeding. By contrast, debt would climb to 90 percent of GDP if current policies continue, the highest point since after World War II.

Tax increases
The Tax Policy Center estimates that if we go over the fiscal cliff, the average American will see their tax bill rise by $3,446 in 2013.

That average obscures a bigger hit to the rich than the poor. Taxpayers making more than a million dollars will, on average, see a $254,000 tax hike, equal to about 11 percent of their income, while taxpayers making between $40,000 and $50,000 will see a $1,700 tax hike, equal to about 4.4 percent of their income, according to tax analysts.

Still, it’s a big hit to both groups, and that’s before you get into the effects of the spending cuts, which will hit the poor much harder than the rich.
Has Washington tried to solve the fiscal cliff in the past? The simple answer is yes, but so far with short-term solutions – which is the problem.

2010 tax deal
The Bush tax cuts were actually scheduled to expire in 2010. Republicans wanted to make them permanent when they were initially enacted in 2001 and 2003, but compromised to avoid a filibuster forced them to accept a 10-year expiration date.

In late 2010, both President Obama and Congress passed legislation extending the Bush tax cuts for two years, agreeing that the economy was too weak for a tax hike. Although the economy has improved, most analysts would agree that the economy can’t take this type of economic contraction. The deal was also contingent on a two-year extension of federal unemployment benefits, which were included in the 2009 stimulus, a one-year payroll tax holiday to replace another tax break in the stimulus (later extended to two years), and the extension of a few other tax breaks from the stimulus. All of these provisions are due to expire at the end of this year, which is why they’re part of the austerity crisis now.

Obama created the Simpson-Bowles commission in 2010, whose members created a recommended framework for $4 trillion in deficit reduction. But the plan did not attract the required 14-vote supermajority to be sent to Congress. Later, a bipartisan group of Senators known as the Gang of Six tried to build on Simpson-Bowles to formulate their own deficit reduction plan, but their effort, so far, hasn’t had any more luck.

Budget Control Act
Ultimately, to avoid a debt-ceiling crisis, Congress and the White House passed legislation in August 2011 known as the Budget Control Act, which had nearly $1 trillion in upfront cuts and established a Congressional committee to come up with $1.2 trillion more in deficit reduction by late November 2011. If the super committee failed to agree upon a deal, the across the board cuts to both defense and non-defense spending—i.e. the sequester—would be automatically scheduled to take effect after December 31st.

A 12-member super committee deliberated through the fall of 2011, but ultimately failed to come to an agreement by the deadline. The roadblock, once again, was revenue. Let’s just say that party lines were the disagreement with no compromise. Even after the super committee failed, Congress could have independently passed a deal that reduced the deficit by $1.2 trillion to avoid the sequester cuts. But the 2012 campaign soon took precedence and both parties agreed that nothing would get done until after the election.

That’s why we’re now facing the sequester, on top of the Bush tax cuts and other provisions that were already scheduled to expire on December 31st. They’re all policy decisions that Congress has made (or failed to make) over the past two years, piled onto a single deadline.

What do the parties agree on? They all agree it shouldn’t happen for all the right reasons…both parties agree that doing nothing and letting all the scheduled tax hikes and spending cuts to take effect for all of 2013 would be harmful for the economy, and something they want to avoid. No one likes the sequesters, which are described as indiscriminate, across the board cuts, and few want to raise taxes significantly on the middle-class.

What do they disagree on? They take traditional party lines. They don’t agree on taxes: Democrats want to hike taxes on the wealthy by about $1.6 trillion, and they want about $1 trillion of that to come from letting the top tax marginal tax rate snap back to its Clinton-era level of 39.6 percent. Republicans oppose tax increases in general and increases in marginal tax rates in particular.

The two parties also disagree about how and where to cut spending: Republicans want to make more dramatic reforms to Medicare, Medicaid, and other entitlement programs, as well as bigger cuts to domestic discretionary spending.

Now that we know what the fiscal cliff is, let’s examine some possible solutions.

Just go over
The simplest option for Congress and the White House would be to do nothing. Taxes would go up. The military and domestic spending cuts in the sequester would bite down. This would be the single largest act of debt reduction in American history, cutting some $1.2 trillion from the deficit over the next two years. Trouble is, that much austerity would likely also induce a recession. That’s why few policymakers advocate this scenario.
There’s another problem with this plan. Lawmakers can’t just sit back and do absolutely nothing. Even if the tax hikes and spending cuts kick in, Congress would still need to vote to lift the $16.4 trillion debt ceiling by February or so. Otherwise, the United States government would no longer be able borrow money to fund its obligations.

Go over and then make a deal
Another possibility is that lawmakers don’t reach a deal by December 31st, and we go over the cliff. But it’s only temporary. After all, those tax hikes and spending cuts don’t kick in with full force immediately. They’re spread out over two years. So there’s still time to make a deal when the new Congress convenes in January.

Why would lawmakers do this? It might make a deal easier. Right now, the two parties are having a tough time reaching an agreement because Democrats want higher taxes on the wealthy and Republicans mostly refuse to vote for any tax increases at all. But if we go over the cliff, taxes automatically go much, much higher than either party wants. Now the two parties simply need to debate how to cut taxes from this new baseline. That may be an easier discussion, in theory.

The downside is that Congress and the White House might not have much time to negotiate a deal in January or February before financial markets get nervous, which is never a good thing.

There’s nothing stopping Congress and the White House from postponing the fiscal cliff until 2013 or 2014. Congress would simply vote to extend all (or some) of the Bush tax cuts and payroll tax cuts. Then Congress votes to override the sequester, so that none of the military and domestic spending cuts kick in. Suddenly, the fiscal cliff is gone – or at least pushed back.

The upside here is that there’s no recession. The economy gets time to mend. The flip side is that deficit would continue to grow–the CBO estimates US debt would be $1.2 trillion higher over the next two years if Congress extends everything, compared with if we went over the cliff. Plus, we’d face another big showdown two years from now.

New deadline or trigger
One alternative to extending the fiscal cliff that wouldn’t require immediate deficit reduction, or the immediate formulation of a deal, would be to design a new trigger. There are several possible forms such a trigger might take, including cuts to tax expenditures, an increase in the capital gains tax, or more spending cuts.

Smaller chunks
Congress doesn’t need to make a big sweeping deal on the debt right now. It could do something smaller. One possibility being talked about is that Republicans would let the Bush tax cuts for income over $250,000 expire, as Obama wants. That would raise about $80 billion in 2013. In return, Democrats would find $80 billion in spending cuts. Then Congress extends (most) of the rest of the tax cuts.
That’s a small bit of austerity next year, but nothing like the full cliff. And lawmakers could continue working on bigger tax reform in 2013.

Grand bargain
At the moment, there’s a lot of talk in Washington about a “grand bargain” between Republicans and Democrats. This would involve avoiding sharp austerity in 2013. It would also involve some mix of spending cuts and tax increases that are gradually phased in over the next decade, so as to slowly bring down the national debt. It would also include substantial changes to entitlement programs like Social Security, Medicare and Medicaid. Examples of a “grand bargain” framework include the Simpson-Bowles plan, or the Domenici-Rivlin plan.

What about real estate? Here are four areas of concern.

Increase in Capital-Gains Tax

The White House wants “the rich” to pay more taxes. Republicans are opposed to any increases in taxes. But if the Bush tax cuts are allowed to expire, capital-gains tax rates will go up as of January 1, meaning anyone who sells their home could owe more on those sales. As a result, many sellers are racing to close before 2013. If the Bush tax cuts are allowed to expire, the current capital-gains tax of 15 percent will rise to 20 percent. Plus, the new federal health-care tax of 3.8 percent on investment income also kicks in next year for couples who make $250,000 or more. The combined tax-hiking impact of the Bush tax cuts ending and the looming 3.8 percent Medicare surtax.

Capital-gains rates could remain unchanged if a deal gets done in Washington. But don’t count on it.

Expiration of Mortgage Interest Deduction
The mortgage interest deduction — long considered the centerpiece of American homeownership — is on the chopping block. Presently, interest on loans up to $1 million can be deducted on primary and secondary homes. Be prepared for this Holy Grail of housing to either be eliminated or scaled back considerably.

Expiration of Mortgage Debt Forgiveness Act
Short sellers could be in for a big surprise come January 2013, if the Mortgage Debt Forgiveness Act expires. If this law perishes, short sellers will be taxed on unpaid mortgage debt, which the IRS considers taxable income.

If this law dies, thousands of distressed borrowers will avoid short sales (because of the tax hit) and simply walk away from their underwater homes, possibly sending foreclosure filings upward in 2013. Moreover, home sales would decrease nationwide, putting downward pressure on home prices.

Bailout of Federal Housing Administration
The Federal Housing Administration is nearly insolvent and it could require a taxpayer bailout next year. The 78-year-old agency is $34.5 billion short of its legal capital requirement.

These aren’t the only issues threatening the real estate market. Since Fannie Mae and Freddie Mac were taken over by the government in 2008, taxpayers have plowed $180 billion into them to keep them operational. A decision needs to happen within the next couple of years.

So what is the solution? Obviously, we cannot continue to delay decisions on the Federal debt. We’ve kicked this can down the road for too long. Some hard decisions need to be made, the question is when and which ones. There are no easy answers.