Why Not Just Fall Off the Fiscal Cliff?

Contrarians and some politicos on both the left and the right have started to ask the forbidden question

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As everyone knows by now, considering all the talk by market pundits and business media, fear of falling off the fiscal cliff has become the obsession du jour ever since President Obama won re-election. The threatened results of a failure to resolve the issue – including tax hikes, spending cuts and an almost certain recession – sound so dire that nobody wants the U.S. to fall off that cliff.

Then again, maybe some do. Contrarians and some politicos on both the left and the right have started to ask the forbidden question: Why not just fall off the fiscal cliff?

For example, conservative thinker Marc A. Thiessen of the American Enterprise Institute dared suggest in an opinion piece for The Washington Post on Monday that the best way to start the new year in a bipartisan fashion would be to head over the cliff.

“Today, the only ones in Washington who advocate fiscal cliff-diving are liberal Democrats. It’s time for conservatives to join them. Letting the Bush tax cuts expire will strengthen the GOP’s hand in tax negotiations next year, and it may be the only way Republicans can force President Obama and Senate Democrats to agree to fundamental tax reform,” Thiessen wrote.

True enough, liberal Paul Krugman in a post-election column for The New York Times on Nov. 8 urged Democrats not to make a deal in terms of accommodating Republican demands.

“I don’t mean to minimize the very real economic dangers posed by the so-called fiscal cliff that is looming at the end of this year if the two parties can’t reach a deal,” Krugman wrote. “The looming combination of tax increases and spending cuts looks easily large enough to push America back into recession. Nobody wants to see that happen. Yet it may happen all the same, and Mr. Obama has to be willing to let it happen if necessary.”

Facing What May Become Reality

After the Dec. 31 deadline, if no compromise is reached, both the Bush-era tax cuts and the Obama administration’s payroll tax cut are scheduled to expire. At the same time, $1.2 trillion of automatic “sequestration” spending cuts divided equally between defense and non-defense discretionary programs are set to kick in.

Some market participants are girding themselves to face the reality of Washington gridlock if lawmakers fail to reach any kind of a fiscal cliff compromise, whether it’s a continued kicking of the can down the road or a grand bargain.

Mike Acton, director of research for AEWFor example, Mike Acton (left), director of research for AEW, an institutional investment manager that focuses on real estate, said that contrarians are arguing that if tax rates go back to where they were 10 years ago, it would generate as much as $4.5 trillion of new revenue.

“So if in January the Bush tax cuts went away, that would allow $1.5 trillion of reduction in the debt ceiling as called for by the deficit supercommittee,” Acton said. “They created that as a way to force an agreement.”

Acton noted that falling off the cliff would mean that the capital gains tax, dividend tax, estate taxes and personal income tax rates would all go back up.

“By letting the tax rates go back to where they were, it would help everybody,” Acton said. “It would make the rating agencies happy, and both parties could agree to cancel sequestration because they would have created $4.5 trillion of deficit reduction by letting the tax rates expire. Then in the new year, they could come back in and cut whatever taxes they wanted to cut, and politicians love telling voters that they’re cutting taxes.”

Advantages of Falling

Similarly, Katie Nixon, chief investment officer of wealth management at Northern Trust, pointed to the advantages of falling off the fiscal cliff, saying that falling off the cliff would negatively hit real GDP growth by 0.5% in 2013, but that by 2022 GDP would be at 2.3%. That compares with a compromise scenario that preserves the Bush tax cuts and would raise GDP by 1.7% in 2013 but only by 2.1% in 2022.

Off-the-cliff unemployment would be 9.1% in 2013 versus a compromise rate of 8.0, and either way, the jobless rate would total only 5.3% by 2022, Nixon predicted. And the greatest advantage to falling off the fiscal cliff would be a public-debt-to-GDP ratio by 2022 of only 58.5% versus a compromise ratio of 89.7%, she asserted.

But, Nixon said, she doesn’t believe lawmakers will push the U.S. economy off the fiscal cliff. “I don’t think anyone believes rationally that we’re going to get a grand bargain,” she said. “It will likely be a more compromise-driven dialogue.”

To be sure, plenty of the nation’s leaders are urgently seeking such a compromise.

Former Republican Sen. Alan Simpson and former Clinton administration budget director Erskine Bowles brought a message of fiscal restraint and reform to Schwab Impact 2012 on Nov. 15, and the packed house of advisors in Chicago roundly applauded and voiced support for their efforts. Simpson said he was particularly infuriated with both Republicans and Democrats who were speaking openly of the political benefits that could accrue from going over the cliff, while Bowles was frustrated with the lack of activity in Congress.

Perhaps Winston Churchill, said AEW’s Acton, could best sum up the final outcome of the fiscal cliff fight. Quoting the former British Prime Minister, he said: “We can always count on the Americans to do the right thing, after they have exhausted all the other possibilities.”

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Read Gil Weinreich’s Averting Fiscal Cliff Requires Special Type of Leadership at AdvisorOne.

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