“Fiscal Cliff” Remains an Ongoing Saga for Country
by Ron Muhlenkamp, originally published in the Pittsburgh Business Times, January 18, 2013
To welcome in the New Year, Congress and the Obama administration have addressed one side of the deficit problem: government revenues (taxes). For most Americans, they’ve gone halfway, keeping income tax rates at prior levels for those couples earning less than $450,000 per year; refer to 2013 tax table. But they also allowed the payroll “tax holiday” to expire, so automatic deductions for FICA (Social Security) taxes will increase by 2% of gross pay for nearly all wage earners. This will help fund the Social Security program (which now pays out more than it takes in on an annual basis), but will, of course, decrease take-home pay for nearly all wage earners by this same 2 percent. In my opinion, this 2% cut in take-home pay, as well as increases in tax rates on dividends and capital gains, will serve as a drag on the economy. This will slow an already tepid economy, but is probably not enough (by itself) to drag us into a recession.
|2013 In come Tax Brackets|
|Married Filing Jointly|
|Taxable Income||Tax Rate|
|$0 – $17,850||10.00%|
|$17,850 – $72,500||15.00%|
|$72,500 – $146,400||25.00%|
|$146,400 – $223,050||28.00%|
|$223,050 – $398,350||33.00%|
|$398,350 – $450,000||35.00%|
|Source: Tax Foundation|
So we have clarification on what tax rates are going forward, but Congress has not yet addressed the greater issue of federal government spending. In fact, by deferring the sequestration portion of the “Cliff” for two months, it has effectively increased spending and, therefore, the deficit for this fiscal year. The basic problem in government spending is that our politicians have made promises they are unable to keep. A simple example in Medicare… Medicare was enacted in 1965. To the average retiree over age 65, the current Medicare schedule promises benefits which are three times what they’ve paid into the program. This was viable in the past when the ratio of workers to retirees was 3:1, but due to baby boomers retiring we are rapidly transitioning (in the next 10-15 years) to a worker-retiree ratio of 2:1. Simple arithmetic says that to remain viable, Medicare taxes must increase by 50%, benefits must be cut by one-third, or some combination of the two. But no one wants their benefits to be cut, and if you raise tax rates too high, people will lower their incomes as they did in the 1970s. (Remember tax shelters?)
So far, Congress has chosen to deal with the problem by borrowing money—or, more accurately, to not deal with the problem by not passing a budget and yet borrowing money. In each of the last four years, the borrowing has exceeded $1 trillion, or over $10,000 per U.S. household. And, so far, this has worked. Generally speaking, both on a personal or national level, if the amount you must pay to service debt grows at a slower rate than your revenue, the debt burden does not increase and your position is sustainable. But any one of several variables can upset the pattern:
- If the debt itself becomes too big relative to Gross Domestic Product (GDP)… Historically, countries have difficulties borrowing at low rates when debt-to-GDP approaches 100 percent. The U.S. is now there.
- A rise in interest rates generally.
- Lenders see better alternatives; i.e. if other countries deal with their deficits before we do.
- Lenders, foreign and domestic, may gain or lose confidence by how a country deals with its deficits; e.g. Canada in the mid-1990s versus Japan and much of Europe.
When faced with a downgrade to its debt rating in the 1990s, Canada cut the rate of government spending (relative to GDP) and has thrived ever since. For over a decade, Japan and much of Europe have attempted to increase growth in GDP by increasing government spending. It has not worked; Japan and much of Europe are now reentering recessions.
So far, the U.S. has looked good relative to other countries (the least ugly sibling), and the U.S. Federal Reserve has been able to drive interest rates down, keeping our debt service contained. But recent attempts to drive rates lower have been ineffective.
Since 2000, the U.S. has been on an accelerating track similar to Japan’s, (or Spain’s… Portugal’s… Greece’s). Congress is gearing up to discuss the deferred sequestration and the debt ceiling in the next 60 days. I expect this will be as bitter a discussion as any we have had recently—and is the discussion we must have. What our government decides in the next few months about government spending probably sets our course until the mid-term election in 2014 and likely beyond. The saga continues…