Preliminary Thoughts on the "Fiscal Cliff" "Deal"

Ron's Preliminary Thoughts on the “Fiscal Cliff” “Deal”

There are several reports already regarding the personal financial and tax planning consequences of the fiscal cliff deal.  Rather than discuss all of these provisions in more detail, I’d like to comment about two aspects of the recent “deal” to avoid the “fiscal cliff” – by first discussing “winners and losers.”  I’ll then turn to the “next cliffs,” with some questions about the parties’ strategy, but with greater inquiry as to why certain parts of the puzzle are not being considered more greatly – both as to procedural and substantive issues.

WINNERS AND LOSERS.

RETURN OF FULL MEDICARE TAXES.  The biggest impact for most Americans is the expiration of the 2% cut off Medicare employee contributions.  This was designed to be a temporary two-year cut to aid the economy, paid for by adding to the accumulated national debt.  It is no surprise that this “tax break” expired.  Employees will feel real pain – with lower net paychecks in 2013.  This is our most compelling reminder that pulling back on stimulus to the economy – whether fiscal or monetary – can be most painful.

MARGINAL TAX RATES RISE FOR HIGH EARNERS.  For individuals with greater than $400,000, and married couples with greater than $450,000, of ordinary taxable income – roughly 2% of all Americans – income tax rates will also increase.  But only for income above these previously stated levels.  However, the return of the elimination of certain itemized deductions, for income above certain levels, will also hurt high earners.

THE ASSET RICH – NOT SO HARMED.  Those “wealthy” who derive a lot of income from dividends and/or capital gains should be pleased.  The 20% rate on long-term capital gains was anticipated.  The compromise to permit qualified dividends to be taxed at 20% is the larger surprise, and a real benefit to those Americans who own stock (within taxable accounts) in publicly traded corporations, and to those who own stock mutual funds in taxable accounts.  Additionally, greater certainty in planning for gains (and other tax preference items) will result due to the “permanent” patch to the alternative minimum tax.  The preservation of the $5m federal estate tax exemption ($10m for married couples) is another big "win" for the "asset rich."

FEDERAL GOVERNMENT AGENCIES AND THEIR EMPLOYEES.  By punting on the “sequester” for two months, most federal government agencies – many of them facing 8% to 13% budget cuts – still face similar cuts, if the next “sequester cliff” is not addressed.  The agencies should continue feel constrained in their hiring and expenditures, and employees are left to wonder about probable furloughs (mandatory days off without pay) and/or layoffs.

STRATEGY ... THE ROAD AHEAD IS MORE DIFFICULT FOR THE DEMS.

The “debt ceiling cliff” and the “sequester cliff” still exist, with February and March deadlines.  Here are some thoughts about the road ahead.

Both parties have moved from intransigent positions and have compromised, albeit only with the substantial assistance and intervention of V.P. Biden and Senate Majority Leader Mitch McConnell (again).  While some will opine that the compromises made now will make further compromise less likely, I believe the opposite is true.  The new Congress, with a slightly different make-up, and having finally learned to compromise to accomplish “something,” is more likely to reach deals.

Did the Democrats use up most of their leverage, by focusing on eliminating tax increases for all but the high earners?  What incentives do the Republicans possess to avoid the “sequester” on government spending?  Moreover, Republicans appear to possess the upper hand in demanding cuts to entitlement spending to avoid the debt ceiling – and the sequester.  I wonder if the Democrat’s perceived short-term victory in achieving the recent “deal” will turn out to pose long-term difficulties in negotiations.

If, however, real tax reform is to take place – by simplification, elimination of many deductions, and lowering of tax rates, then the Democrats may be better-positioned to head into such “revenue neutral” discussions with higher marginal rates on high earners already in place.

SOME SUGGESTIONS FOR MEANINGFUL REFORMS.

This is a lousy way to run tax policy.  Here are some better ways, in my view, to go about things in Washington, DC.  (I provide, as well, some thoughts on specific spending cuts and tax increases.)

• We should be focusing first on ways to make American corporations more competitive.  Reforming and lowering corporate income taxes is one key.  And removing the burden of employee health care from larger corporations is another (although this would require massive changes to how health care is funded in this country).  Like it or not, the United States competes with other nations in a global economy.

• Next, let’s focus on tax simplification.  Not just by a bit, but by a lot.  No just by lowering tax rates and eliminating most deductions and credits (a good thing, in my opinion), but also by making our government more efficient and reducing the need for tax and compliance consulting.

• For example, what if all IRAs and defined contribution plans were combined into one type of defined contribution plan – all with the same tax, contribution, and distribution rules (and penalties).  It would be a lot easier to administer (under ERISA), and save a lot of money spent at the Dept. of Labor (EBSA) and by tax attorneys, CPAs and retirement plan administrators across the country.  Imagine if defined benefit plans were simplified, as well.

• Tax increases and spending cuts should be phased in - via a new long-term annual sequester process.  As we’ve seen, from all of the recent economist warnings, huge “cliffs” in either reduced government spending or increased taxes can result in the likelihood of recession.  Common sense informs us that federal debt reduction shouldn’t be – as the fiscal cliff set up to do – a huge precipice of either tax increases or spending cuts.  

•  One of the strategies used to get people to save is to set aside an increased amount (as a percentage of income) for savings (or debt reduction).  Why not do the same for the federal government?  Mandate a reduction (in real, or inflation-adjusted, terms) of some percentage amount in overall spending each year (such as 1%, 1.5% or 2% a year), and revenue increases (i.e., tax increases) also in real terms (such as 1%, 1.5% or 2% a year).  Mandate this for ten years. 

• The difficulty in adopting a ten-year plan for spending cuts and revenue increases lies in determining “how much.” But that’s the real “grand bargain” that needs to be made.

• If done correctly, this phased-in, mandatory annual sequester approach will quiet the concerns about increases in debt-to-GDP levels “forever,” while at the same time providing a more stable tax and spending policy in the near term.  In other words, economic growth can proceed, as business and consumer confidence will be restored.  And with confidence restored will come further impetus for economic growth.

• In summary as to this point, we can make a lot of progress if Congress were to vote to enact rules to force ten years of phased-in spending cuts and tax increases, through an annual sequester process.  We’ve seen this before – and despite the sometimes difficulties it caused in the political process – it worked! 

• [By way of further explanation, the Balanced Budget and Emergency Deficit Control Act of 1985 established an annual sequester as a means to enforce statutory budget limits.  Amendments to this act were designed to use sequesters to control direct spending and revenues (through the pay-as-you-go, or PAYGO, process) and discretionary spending (through spending caps).  (Sadly, those mechanisms expired October 1, 2002.)  Previously, under these mechanisms, the budgetary impact of all legislation was scored by OMB, and reported three times each year (a preview with the President’s budget submission, an update with the Mid-Session Review of the Budget, and a final report after Congress adjourned). If the final report on either the PAYGO or spending caps mechanism indicated that the statutory limitations within that category had been violated, the President was required to issue an order making across-the-board cuts of nonexempt spending programs within that category.]

SOME SPECIFICS.   In order to avoid being labeled as just another pundit fearful of providing specific solutions, I offer several (and many more should be considered):

• The raising of tax revenues in the short-term by encouraging greater conversions to Roth IRAs and Roth accounts is poor long-term tax policy.  The Roth IRA (and other Roth accounts) are huge give-aways to taxpayers, which - in my opinion - the government can ill-afford.  As much as they are long-term beneficial for my clients (and their heirs), they don’t bode well for the long-term financial security of the country.  Sadly, we need to eliminate further contributions and conversions to Roth accounts.

• Reduced Pentagon spending will occur.  Great strides have been made in recent decades in cutting obsolete weapons programs and closing unneeded military bases.  Greater strides still need to be made, still.  The Secretary of Defense’s job will be a tough one, over the next decade, as the Defense Department wrestles with reduced levels of funding.

• Chained CPI will occur.  The door has been opened to its consideration.  But it is not the only solution to entitlement spending.  We must also consider a phase-in of a higher Full Retirement Age for Social Security retirement benefits, a slightly higher age for Medicare eligibility, and higher Medicare taxes (employer and employee contributions) over time.  The longer we wait, the more severe the remedy.

• Let’s simplify Medicare while we are at it.  Eliminate Medicare Part C (which costs the government tens of billions more than it should, anyway).  Combine Parts A, B and D, and make B & D mandatory.  This should greatly reduce administrative costs in the Medicare system.  And, of course, permit Medicare (or non-profit associations acting as payors) to negotiate prescription drug prices.  And let’s open the discussion about reducing the costs of end-of-life care, by having an honest discussion about it (with no “death panels” rhetoric).

CLOSING THOUGHTS.

Let’s get away from the “unified budget” numbers.  It understates our real annual budget deficit.  (I lay some blame with the press, for permitting the politicians to continually referred to the “unified budget” numbers when reciting the size of budget deficits.)

Campaign finance reform is essential (and it may require a Constitutional amendment).  And term limits for those in Congress should be reconsidered.  As we have seen, far too many in Congress cast votes in anticipation of the next primary or general election.  Going to Washington should be viewed as an opportunity to temporarily serve the country, and not as the necessity of preserving one’s permanent seat.

It may take some time to digest all of the “deal” which has been approved.  We can only hope that the process used to achieve tax and spending reform (i.e., deficit reduction) – while never easy – can be undertaken in Washington with a great deal more thought, and courage - in the future, when contrasted to what we have seen over the past two months.

Largely due to Congress’ inability to tackle problems in a sensible way, too many Americans worry that America is in permanent decline.  Let us hope, and pray, that current and new leaders will embrace a more sensible path toward addressing the country’s problems, with a long-term perspective.  Let us hope that statesmen and leaders emerge to guide us toward a prosperous future.

I am optimistic.  America is a great country, and with unbundled enthusiasm, its entrepreneurial spirit, and the promises from continued innovation, we can continue to remain a great country - and a great people.  But, to maintain this greatness, we must demand more from our elected leaders.  Each and every one of us should write to our representatives in Congress and demand statesmanship rather than political posturing.

In conclusion, the recent outcome of the "fiscal cliff" "deal" did little to restore the all-essential business and consumer confidence our country needs to assist in propelling our economic growth.  It did avert the "fiscal cliff" - but not by addressing our long-term fiscal issues, as was intended.  Let us hope that over the next two months we will witness a process, and outcomes, far more satisfactory.

Ron A. Rhoades, JD, CFP(r)

January 1, 2013