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Investor enthusiasm over fiscal cliff deal will be short-lived

January 2, 2013: 11:03 AM ET

It doesn't take a math genius to understand that this grand compromise to avoid the dreaded fiscal cliff is highly inadequate.

By Cyrus Sanati

<> on July 31, 2011 in Washington, DC.FORTUNE -- The "fiscal cliff" may have been averted but the nation's debt problems remain very much alive, setting the stage for yet another fiscal mini-crisis in the very near future. The agreement hammered out over the last two days between Republicans and Democrats raises a trivial amount of revenue while delaying the implementation of supposedly "mandatory" spending cuts for another two months. While Wall Street initially cheered this half-baked solution, the delayed spending cuts and the looming debates on extending the debt ceiling will eventually chip away at investor confidence, translating into increased market volatility.

The fiscal cliff, which was essentially created by Congress and the President with the Budget Control Act of 2011, was averted by the exact same Congress and President Tuesday night with the passage of the American Taxpayer Relief Act of 2012. With the stroke of a pen, the nation was pulled back from this politically manufactured precipice with a flawed plan that does little to address the nation's long, or even its short term, fiscal problems.

In brief, the compromise ensures that most Americans will pay more in taxes this year than they did in the last two years, with the nation's highest earners, those taxpayers with incomes of more than $400,000 for individuals or $450,000 for married couples filing jointly, taking the brunt of the hit. This relatively ultra-rich group will see their federal tax rates increase from 35% to 39.6% - the rate before the implementation of the Bush-era tax cuts. This group will also pay higher tax rates on investment income, with rates on capital gains and dividends rising from 15% to 20%. This is in addition to the 3.8% "Obamacare" surcharge on investment income scheduled to go into effect today, bringing the top rate on investment income to a sobering 23.8%.

These tax increases on the wealthiest Americans have conservatives in a tizzy that it could cause a decrease in investment spending, hurting the nation's modest economic recovery. But while it is true that some taxpayers in this group might be deterred from investing, it is unlikely that it would make any difference one way or another in the health of the overall economy given just how small this group is on the overall investment landscape of the country.

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Indeed, President Obama had originally wanted the higher tax rate to impact a much larger group of Americans, those making above $250,000 a year, but Republicans dug in their heels, forcing the President to raise the threshold up to the $400,000 mark. But single individuals making above $250,000 a year and couples making above $300,000 aren't getting off scot-free. This relatively wealthy group will no longer be able to claim a personal exemption on their taxes, wiping away a benefit worth around $3,800 for most individuals last year. This group will see 80% of their deductions eliminated this year, including those for charitable donations and those on mortgage interest.

But the biggest fiscal impact will come from the end of the two-percentage point payroll tax cut instituted by President Obama in 2010. The move will hit all U.S. workers immediately and is expected to pull a whopping $100 billion out of the U.S. economy this year. The end of this lucrative tax cut is the primary reason why three-fourths of households will pay more in taxes this year, according to the nonpartisan Tax Policy Center.  It is here that the economy will be most impacted as poorer Americans tend to spend all of their income, stimulating the nation's consumer-driven economic model.

Surely the U.S. is on the right fiscal footing now, right? Hardly. Indeed this massive tax hike, one of the largest in U.S. history, doesn't even come close to bringing in enough revenue to cover the nation's bills, let alone enough to address the national debt. The White House proudly claims that the tax hikes will raise $62 billion a year in revenue over the next decade. That's nice, but the 2011 budget deficit rang in at $1.1 trillion.

It doesn't take a math genius to understand that this grand compromise to avoid the dreaded fiscal cliff is highly inadequate. By allowing the vast majority of the Bush-era tax cuts to continue, the President and Congress have added nearly $4 trillion to the national debt over the next 10 years, according to the Congressional Budget Office.

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What is missing from this compromise are two big things – a realistic increase in tax rates on the middle class, essential to raising any meaningful amount of revenue, and major spending cuts in entitlements and military spending. Tax cuts on the middle class, for now, seems to be a dead issue, so the only way to fix the nation's debt woes is to cut spending in a major way.

The "sequester," the automatic spending cuts that were supposed to take effect today, were deferred by two months as Congress passed the buck to the new Congress which is set to be sworn in on Thursday. Those automatic cuts in defense and entitlement spending would have eliminated $110 billion in spending this year and $1.2 trillion in spending over the next decade. While not enough to seal up the nation's fiscal hole, the cuts associated with the sequester would have been a good start.

But Congress simply couldn't bear to cut anything this time around. Who can blame them? The negative impact from cutting that much money off the Federal budget could have catastrophic consequences to the economy in the short run. The nation is able to borrow cheaply to fund its excess, so it doesn't feel the need, like many of its profligate-spending European counterparts, to take on austerity and revenue raising plans at the same time.

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The next major crisis will therefore come as the nation approaches the self-ascribed "debt ceiling" in late February or early March. Republicans might again attempt to hold the nation hostage like they did two years ago by refusing to automatically extend the ceiling. Meaningful reform is needed on the spending side of the equation but messing with the debt ceiling is a big market negative. Last time the Republicans made a big fuss over it, Standard and Poor's, the ratings agency, cut the nation's credit rating by one notch. While that first cut didn't impact demand for US debt, another cut so soon after the first could have an impact on the nation's ability to raise debt, increasing debt funding costs unnecessarily.

The markets will be watching Washington intently, looking for signs that the new Congress and President Obama can come to a viable and meaningful deal on the debt ceiling and the sequester. Hopefully they can come to an agreement which balances the short term and long term needs of the nation – but I wouldn't hold my breath.

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