The Cliff, The Deficit and What It Means To You

A few weeks ago (the December 8th entry) I told you that the world wasn’t coming to an end because of the Fiscal Cliff. I said that “it is HIGHLY UNLIKELY that every tax increase and spending cut will, in fact, come to pass. Some compromises will certainly be made by our leaders in Washington, despite the radical bleatings of the far right and far left. Whether the deal is brokered in the next two weeks or the next two months, I’m confident a deal will be made that will leave both sides less than happy but will stave off the worst result, which would be simply doing nothing.“

As I predicted, a deal was struck with much fanfare and with thundering applause from Wall Street which rewarded the hack show by staging a huge two-day rally. That’s the good news. The bad news is that the deal accomplished virtually nothing for the long-term health of our economy. It is simply a tiny band aid on a festering wound. It feels better now but it does nothing to stop the internal bleeding.

The bigger problem is looming: the fight over the deficit and increasing the debt ceiling. And this time, the Republicans in Congress hold the power. Mr. Obama is going to have to negotiate legitimate spending cuts in Social Security, Medicare/Medicaid and other sacred cows whether he wants to or not. I don’t think there’s really any way to avoid it much longer. It’s time to take the medicine. It’s past time for America to tighten its collective belt and start living within its means. As anyone who runs a household or a business implicitly understands, you simply cannot spend more than you earn, going deeper and deeper into debt. Eventually, you either go bankrupt or someone breaks your kneecaps. I believe the national debt is now approximately $17 trillion, give or take a trillion. It’s time to start to reducing this of our own volition before our creditors force Greece-like austerity measures down the road.

But before we get to the debt ceiling drama, let’s see what the Fiscal Cliff agreement means to you and your money. First of all, if you make less than $400,000 (or $450,000 as a couple), you should be pretty happy. The only real change for you is your payroll taxes will rise 2%. The dividend and capital gains taxes remain at 15% and your income tax levels remain where they are. For those high income citizens, you will face the same 2% payroll tax increase, plus you’ll be subject to a higher tax bracket and capital gains and dividend taxes of 20%. None of this is end-of-the-world stuff. The estate tax exemption remains at $5 million which is good news for everyone. So, in the end, this really isn’t a horrible agreement; it could have been much worse. But the flip side is that while it isn’t bad for people, it’s bad for the government as it actually reduces its long-term tax receipts. Hence the looming fight over the deficit.

And what does all of this mean for our investments? The agreement on the capital gains and dividend tax rates are a plus for the stock market. The higher estate exemption is also good for the market. Any increase in payroll taxes, or income taxes, is a net negative, but it really isn’t a huge problem. So for now, we’re ok. We just need to listen to the rhetoric about the deficit and pay close attention to what kind of spending cuts are forthcoming because that will directly affect the economy, which will immediately impact the stock market. So stay tuned.