Running Over the Edge

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As most of you are probably aware, our country is facing a “fiscal cliff” at the end of the year. But what exactly does that mean?

The “fiscal cliff” refers to the combination of the expiration of the Bush Tax cuts that were enacted in 2001 and 2003 and renewed until December 31; the expiration of the 2% payroll tax cut; the expiration of the AMT patch that keeps it from hitting so many of the middle class; the reduction of the exemption of estate taxes from $5 million to $1 million; plus the across-the-board spending cuts that were enacted as a result of the failure of the super-committee to arrive at a satisfactory solution to our deficit and debt problem.

According to Simpson-Bowles of the National Commission on Fiscal Responsibility and Reform, it means that there are $7.7 trillion of economic events headed our way very shortly. This is truly a moment in time of historical importance.

It spite of the widespread use of the word trillion, it’s still really hard for most of us to think about the magnitude of a trillion dollars, much less 7.7 of them. Think for a moment about spending $1 a second for every second of every day. It would take more than 32,000 years to reach a trillion. If you had spent a $1 million a day for the past 2,000 years, you would still only be about three fourths of the way there. And we are talking about 7.7 times that amount to hit all at once! It’s decision time.

However, it appears that nobody in Washington is doing anything about it. In fact, we heard from a person who regularly roams the halls of Congress that there are more than a few members of that body who will be happy to let it happen. Moreover, as of this writing, it has not been addressed by either candidate in the first two of the Presidential debates and is not likely to be mentioned in the third. They surely know what we face, but are trying very hard to avoid even talking about it. We could suppose that some in Washington see it as the opportunity to do nothing further; thereby raising tax receipts while cutting spending all while blaming the outcome on the other party. Some could even see it as a viable solution to the debt and deficit. While it could be a start, it is far from an optimal deficit reduction solution.

From a personal perspective, the cliff will result in a tax increase for everybody on the tax rolls. The nonpartisan Tax Policy Center issued a report in October revealing that it expects the expiring tax provisions to increase the amount of taxes paid in 2013 by $536 billion. That is an average increase of about $3,500 per household. Since our readers are likely to be in the upper tax brackets, the increase is likely to be significantly greater than the average. Furthermore, many states, including Kentucky, generally adopt federal tax rules. The cliff therefore is likely to increase the average of each taxpayer’s state income taxes as well.

Sequestration of the budget will result in cuts to non-exempt government programs from 7.6% to 9.6%. Medicare is limited to a 2% reduction. Social security and Medicaid are not affected. The cuts, while scheduled to take affect over a nine year period are expected to be $109 billion in 2013. Bottom line is that most physicians will see a decrease in income and an increase in taxes.

Many have rightfully wondered what effect this will have on the economy as a whole. We believe that it should be labeled as “austerity” in much the same way that Europe has dealt with its varied crises. Some would conclude that we need that, others argue that it has thrown Europe into recession and because of our size will cause worldwide recession or, in some cases, depression. Christine Lagarde, head of the IMF, has recently warned against too much austerity. Deflation becomes a much greater threat than inflation.

It’s time for bold ideas for permanent reform. Our firm’s economist, Dr. Woody Brock, has called for redefining the deficit. He claims that one cannot talk about deficit without first labeling it either “good” or “bad.” A good deficit would be produced by spending on investments that would reasonably be expected to produce a positive rate of return for many years to come. Interestingly, the math for this was worked out by two noted economists in 1970. When you consider this kind of spending, think about the interstate highway system that dramatically increased productivity or the space program that produced incredible technology. Brock’s plan calls for a Domestic Marshall Plan that would rebuild our nation’s crumbling infrastructure, and would put thousands of people to work, just as our economy needs the stimulus. The bad deficit would be covered by tax receipts and, thereby, eliminated entirely. Such a plan would be respected by the bond market and credit rating agencies alike.

Now is the time for us to call upon our elected representatives to work toward true consensus of a grander plan than either party has put forth to date. So much is at stake and it is not very likely to come about as long as gridlock remains the order of the day in Washington.

Our firm’s economist, Dr. Woody Brock, has called for redefining the deficit. He claims that one cannot talk about deficit without first labeling it either “good” or “bad.” a good deficit would be produced by spending on investments that would reasonably be expected to produce a positive rate of return for many years to come. The bad deficit would be covered by tax receipts and, thereby, eliminated entirely.

Scott Neal is President of D. Scott Neal, Inc. a fee-only financial planning and investment advisory firm. Questions and comments are welcome via email at scott@dsneal.com or by calling 1-800-344-9098.