By Cyrus Sanati
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.
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.
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.
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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* Next step: CalSTRS puts firearms MOREDan Primack - Jan 2, 2013 6:59 AM ET
The political compromise does little to address the consistent headwinds that undermine growth, hold back corporate investment, and dampen job creation.
By Mohamed El-Erian
FORTUNE -- The compromise reached by Congress, after multiple rounds of painful negotiations, makes some political sense. The economic benefits are mixed, at best. The social dimension is notable, but will need to be quickly reinforced by measures to reinvigorate economic growth and job creation.
The political MOREJan 2, 2013 6:47 AM ET
Goldman's head of asset management says investors are starting to think that Europe is doing a better job dealing with debt than U.S.
FORTUNE -- Jim O'Neill, the chairman of Goldman Sachs Asset Management, says President Obama and Republicans have another three weeks to make a budget deal. He says if there isn't a deal to avoid the fiscal cliff by inauguration day, which is officially January 20th, the market will MOREStephen Gandel, senior editor - Dec 28, 2012 5:00 AM ET
The market might have a good reason to be shrugging off the fiscal cliff.
FORTUNE -- For months the predictions for what would happen if we go over the fiscal cliff have been bordering on horrific. The Congressional Budget Office says the chance of recession is 100%. Moody's says it will be much harder for companies to issue debt. PIMCO's CEO Mohamed El-Erian says our children are all but guaranteed to MOREStephen Gandel, senior editor - Dec 21, 2012 1:58 PM ET
It seemed like a great idea at the time: sweeping tax cuts that would never go away because of an endless economic boom. The day of reckoning has come.
FORTUNE -- What seems brilliant today can come back to bite you in the butt tomorrow when the world changes. That's my major takeaway from the fiscal cliff soap opera.
It's a lesson that Republican tax-cutting zealots are now learning, painfully, as their MOREAllan Sloan, senior editor-at-large - Dec 21, 2012 5:00 AM ET
If uncertainty were the issue it would already be slowing hiring. It's not.
FORTUNE -- Earlier this year, economists seemed convinced that even the very threat of the fiscal cliff would send the U.S. plunging into recession. Less than a month away, the economy still appears to be climbing.
The best piece of evidence yet that the fiscal cliff - the massive mix of tax increase and spending cuts that are set MOREStephen Gandel, senior editor - Dec 7, 2012 1:43 PM ET
Whether or not the president and lawmakers reel us in from the fiscal cliff, the tax debate is sure to keep going.
By Becky Quick, contributor
FORTUNE -- It's an argument as old as politics itself: How do we responsibly finance the system of government that provides the basic framework of our society? Taxation without representation was at the core of forming this country. Now the rate and distribution of taxes MOREDec 7, 2012 5:00 AM ET
Top hedge fund manager expects the market to drop on fiscal cliff fears.
FORTUNE -- President Obama's favorite hedge fund manager is worried about the fiscal cliff.
Marc Lasry, who was one of the few vocal Wall Street supporters of the president during the election, has 25% of his portfolio in cash. That's nearly double what Lasry normally has going into the end of the year. The reason is the fiscal cliff. MOREStephen Gandel, senior editor - Dec 6, 2012 12:20 PM ET
Three sectors are shrugging off fear of the fiscal cliff -- here's why.
FORTUNE – As Washington approaches judgment day over the fiscal cliff, the mix of tax hikes and spending cuts prompted CEOs from JPMorgan Chase's (JPM) Jamie Dimon to Honeywell's (HON) Dave Cote to march to Washington for a resolution. President Obama and lawmakers are fiercely politicking to keep the economy from tipping over the doomsday scenario of seeing MORENin-Hai Tseng, Writer - Dec 6, 2012 11:31 AM ET
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