Thursday , 25 July 2024

The Fiscal Cliff: Components, Controversies & Compromises

The term “fiscal cliff” was first coined by Ben Bernanke in early 2012, and it refers to the roughly $718 billion that will be withdrawn in some way, shape or form (4.6% of our nation’s annual economic output) from the economy in 2013 in the form of tax increases and federal spending cuts. If nothing is done, and all the scheduled tax increases and spending cuts go into effect on January 1, the Congressional Budget Office estimates that the economy will contract slightly in 2013. Other estimates (including ours) show a much deeper recession would be likely. Words: 940

So says David Houle,CFA ( in edited excerpts from his original article* entitled Fiscal Cliff Diving.

Lorimer Wilson, editor of (Your Key to Making Money!), may have edited the article below to some degree for length and clarity – see Editor’s Note at the bottom of the page for details. This paragraph must be included in any article re-posting to avoid copyright infringement.

Houle goes on to say, in part:

Congress will work to do something to address the cliff but what the end result will look like is anyone’s guess, but it will probably be a combination of allowing certain components to take affect while “kicking the can” on others.

According to numbers published by Morningstar [see table below], the total size of the fiscal cliff…is made up of the following components:

Nearly 80% of the fiscal cliff comes in the form of tax increases, as broken down in general terms below:

  • Income tax rates rise to a range of 15.0% – 39.6% from 10.0% – 35.0%
  • Capital gains tax rates rise from 15.0% to as high as 23.8%
  • Dividend tax rates rise to from 15.0% to as high as 43.4%
  • Child tax credit falls from $1,000 to $500
  • Estate tax exemption falls to $1M from $5M, top rate rises to 55.0% from 35.0%
  • AMT taxes will apply to roughly 30 million tax payers, up from 4 million
  • Payroll tax holiday expires (additional 2.0% in payroll taxes on first $110K)

…[O]ne of the more controversial components of the cliff is the $109 billion in “sequestration” cuts which are mandated by the Budget Control Act of 2011 (the “Act”). The Act was signed into law by President Obama in August of last year as part of a compromise that allowed for an increase in the national debt limit. This bill established what became known as the “super committee”, a group of 6 Republicans and 6 Democrats tasked with reaching an agreement on how to cut the federal deficit by $1.2 trillion over the next decade. The committee began meeting in early September and was given until mid-January 2012 to enact a plan. As a failsafe, the bill included automatic spending cuts that would go into effect at the beginning of 2013 should the super committee fail to reach an agreement. Wikipedia offers this description:

The agreement also specified an incentive for Congress to act. If Congress failed to produce a deficit reduction bill with at least $1.2 trillion in cuts, then Congress could grant a $1.2 trillion increase in the debt ceiling but this would trigger across-the-board cuts (“sequestrations”).

Similarly, analysis from law firm GreenbergTraurig called the sequestrations an “enforcement mechanism”:

The BCA also includes an enforcement mechanism in the form of an across-the-board “sequestration” of federal funds that strongly encourages Congress to reach a deal identifying at least $1.2 trillion in spending cuts or new revenue.

In other words, the President was granted the authority to raise the debt ceiling only under the condition that $1.2 trillion was assured to be cut from the deficit over ten years, whether via a plan crafted by the super committee or via the forced sequestrations that are now on deck for over 1,000 government programs. These spending cuts are now being called into question, however, and many are proposing that they be delayed or perhaps eliminated altogether….

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If nothing is done, and all the scheduled tax increases and spending cuts go into effect on January 1, the Congressional Budget Office estimates that the economy will contract slightly in 2013. Other estimates (including ours) show a much deeper recession would be likely….Congress will [try] to do something to address the cliff but what [the end result] will look like is anyone’s guess, but it will probably be a combination of allowing certain components to take affect while “kicking the can” on others. The ultimate result is likely to be a drastic reduction in the size of the  cliff towards something closer to $200 billion.

In addition to anticipating what actual changes are likely to be implemented in the post-election aftermath, perhaps equally as important will be anticipating the path taken to achieve those ends. A prolonged and heated Congressional debate over what should be done is likely to extend the timeline and feed the high levels of uncertainty already present amongst business owners and capital market participants. A recent CNBC article highlighted the issue this way:

Some 72 percent of respondents believe investors have yet to price in the ramifications-a view that is spreading across Wall Street as time winds down for a solution. Andrew Garthwaite, global equity strategist at Credit Suisse, said in a note, “Ironically the fear of the fiscal cliff may be as damaging to growth as the actuality of fiscal policy.”

Meanwhile, former Treasury Secretary Larry Summers anticipates fairly swift action on the part of Congress, but only once they’re feeling an adequate level of urgency:

“I’ve been watching Washington for a long time, and one of the things you learn is that sometimes when the need is sufficiently great, the transition from inconceivable to inevitable can actually be fairly quick.”


We don’t expect the U.S. to walk headlong over the fiscal cliff, but we do anticipate the uncertainty surrounding what will be done, and when, will weigh on risk appetites in the meantime.

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Indeed, the fear itself (not the actual event) is often the greatest threat to investment results. We are therefore remaining underweight our long-term targets in risk assets until we gain more clarity or believe risk is adequately priced into the markets.


Editor’s Note: The above post may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.

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