Taxmageddon: Can Anyone Turn the Wheel Before America Goes off the Fiscal Cliff?

November 21, 2012

By Reynolds Cafferata

Americans woke up on the morning of November 7th to this post-election reality: Nothing had changed. Aside from a few new faces, the House was still Republican, the Senate was still Democratic and the president was still Obama. What was different was the cleverly branded financial calamity called the Fiscal Cliff that seemingly sprang up overnight. While nothing fiscal or policy related ever pops up unannounced, this threat has captured American media and public attention. So is this really a cliff, or just a speed bump? The answer will depend on who is driving the car.

For starters, what does the ‘Cliff’ look like? The deficit will shrink to an estimated $641 billion in fiscal year 2012 (or 4.0% of the GDP), almost $500billion less than the shortfall in 2012. Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession with the real GDP declining by 0.5% between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9% in the second half of calendar year 2013.

Given that the political constitution of Washington has not changed fundamentally, the question becomes who will take the wheel? Harry Reid, Senate Majority Leader as well as House Speaker John Boehner agree that both sides will have to make concessions and that reforming the tax code, or our spending, will be part of the plan. Here is how the finer points could potentially play out:

Scenario 1: Harry Reid takes the wheel

  • All cuts extended except upper income cuts and sequestration repealed.
  • Short term best political outcome for Democrats as it gives the appearance of addressing fiscal issues without any pain for most people.
  • Will anyone notice the deficit is still a $Trillion?
  • If any significant” investments in our future” are made, there will be no fiscal benefit.

Scenario 2: Boehner takes the wheel and Obama blinks

  • All cuts extended and sequestration imposed (maybe defense cuts trimmed)
  • If sequestration remains in place about the same fiscal impact as repeal of upper income cuts.
  • Will anyone notice the deficit is still a $Trillion?
  • If sequestration is significantly paired back, no fiscal benefit.

Scenario 3: No one blinks

  • All cuts expire
  • Sequestration cuts
  • Recession in 2013
  • Will anyone notice the deficit is down to $400 billion?

(I can’t help but think that if we stopped calling it a disaster and instead described it as a path to fiscal soundness, some of the effects of the fiscal drag could be offset.)

Scenario 4: The Ride Share

  • Parties agree to the fiscal impact of repealing all Bush era tax cuts and sequestration cuts (or something close)
  • Fundamental tax reform (A fight over who bears the cost will ensue. If people under $250K don’t have any added burden, a five-fold increase on upper income tax payers will be required)
  • Entitlement reform (Slow growth in plans by increasing age, adjusting CPI and increasing co-pays)
  • Aggressive immigration reform could have significant fiscal benefits by improving demographic distribution.
  • Economic benefit of confidence in future may balance drag if reduced fiscal stimulus.
  • Watch for false grand bargain that does not really change the fiscal picture.

Where are we at? At the end of the day, effective planning is the only way to minimize the effects of any of the scenarios.

  • Avoid Medicare taxes by realizing 2012 income.
  • Use the $5 million gift exemption (Romney and Obama both proposed a $1 million gift exemption)
  • CRTs will be far more attractive and are exempt from Medicare taxes.

The fiscal cliff will dominate the news through the end of the year while our electeds decide whether to tighten the belt now or later, and on whom. The best we can hope for is that the process unfolds without unnecessary media or partisan drama.

To read the CBO debt report, please click here.

To read the GAO outlook, please click here.

Thank you for reading,

Reynolds Cafferata

Reynolds Cafferata is partner with Rodriguez, Horii, Choi & Cafferata. Mr. Cafferata’s practice is concentrated in the area of non-profit, tax, estate and trust law.

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