About · Press · Contact · Write For Us · Top Personal Finance Blogs
Featured In:

What Is the Fiscal Cliff – How the U.S. Can Avoid It

By Michael Lewis

fiscal cliffThe fiscal cliff is getting closer, and unless action is taken, the terms of the Budget Control Act of 2011 will go into effect at midnight on December 31, 2012. Congress’s inability to resolve the last budget crisis in August 2011 and the burgeoning national debt led to the passage of the Act to avoid the catastrophic effects of a government shutdown.

In an effort to force an eventual compromise and enact long-term solutions to fiscal irresponsibility, members of Congress passed the Act, which specified severe, automatic cuts to the budgets of the United States Department of Defense and domestic spending programs (sequestration) if a negotiated solution between the political parties could not be reached. To no one’s surprise, there has been no willingness to compromise on either side, and the country is again on the brink of financial disaster.

The Various Impacts of the Sequester

On Citizens
Personal taxes will immediately increase due to the end of payroll tax cuts passed in 2011, a return to tax rates prior to the Bush tax cuts (originally passed in 2001 and 2003), and a reversion to the past calculations of the alternative minimum tax (AMT). Some estimate that the change in AMT alone will raise the tax bill of 30 million Americans by almost $2,700. This increase will also be accompanied by additional taxes related to the healthcare law. In short, if nothing is done, personal income taxes for every American are likely to increase.

On Critical Government Programs
More than 1,000 government programs – including the defense budget and Medicare – will be subject to deep, automatic cuts. Additional forced cuts will affect such programs as housing and energy assistance for poor people, and grants to states for programs like drinking water infrastructure and airports. The cuts will likely result in the termination of 25,000 teachers, and reductions in research funding ranging from the National Science Foundation to the National Cancer Institute. Payments to Medicare providers, already under pressure due to low reimbursement rates, will be slashed.

On the American Economy
The Bipartisan Policy Center projects that, if the Budget Control Act goes into effect, the economy – still struggling from the 2009 recession and the financial difficulties experienced by countries around the globe – will lose more than one million jobs, and the nation’s gross domestic product (GDP) will fall one-half of 1%, rather than grow a hoped-for 1.5% to 2% in 2013. The Congressional Budget Office predicted a decline of 4% in GDP in the first quarter of the new year, enough to trigger another recession, if the Act goes into effect.

The Political Impasse

This crisis is self-made, the result of extreme ideologies in both political parties who have been unwilling to compromise their positions for the good of the nation as a whole. Virtually every elected Republican has pledged never to raise taxes in line with a pledge to Grover Norquist’s conservative lobbying group Americans for Tax Reform. Norquest proudly proclaimed to the Huffington Post, “It’s been 22 years since a Republican voted for a tax increase in this town [Washington, D.C.].” Republicans willing to compromise on increased revenues like Senators Saxby Chambliss (GA), Tom Coburn (OK), or Bob Corker (TN) are likely to face extreme conservative Republican opponents in the next election, despite their high ranking from the American Conservative Union.

Democrats like Senator Harry Reid and Nancy Pelosi have taken equally strong positions against any changes in Social Security and Medicare, programs that clearly need change to survive for future generations.

congress must act to avoid the fiscal cliff

The Great Compromise

For the past four years, senators and representatives of both parties have acted as if they were engaged in a “winner-take-all” game, betting that the rest of the country is willing to accept a continued stalemate and a do-nothing Congress. Employing a single strategy – raising taxes or cutting expenses –  is contrary to the majority of Americans’ preferred approach, which is to reduce the federal budget deficit by a combination of the two, according to a November 14, 2012 Gallup Poll.

If Congressional leaders can put the needs of the country above partisan politics, the crisis can be averted by taking the following measures:

1. Waiving the Budget Sequester

Some have suggested that “going over the fiscal cliff” – letting the Act go into effect while refusing to raise the national debt limit – wouldn’t immediately hurt the economy and would make it easier for the respective sides to make a “grand bargain.” But it would be the worst possible outcome. An inability to fix the problem will signal that the Congress is not serious about fiscal responsibility and cannot govern.

Our inability to initially deal with the growing deficits resulted in the Budget Control Act and a drop in the financial rating of the country’s debt. A second failure would be more consequential, particularly in a world searching for economic leadership. The political party – Republican or Democratic – believed by the public to be unwilling to compromise will pay an enormous price in elections to come.

2. Extending the Bush Tax Cuts With Limits on Deductions for the Highest Earners

The Republicans want to extend the Bush tax cuts across the board to all taxpayers, while the Democrats propose the extension be limited only to those with annual incomes less than $250,000. While Democrats would prefer to raise taxes on incomes over this amount, they may compromise such that the tax cuts be extended to all (regardless of income), but with new limits on the deductions. Limiting deductions and exclusions has the same effect as increasing the tax rate, thereby accomplishing the Democrats’ intent to increase tax revenues.

This solution allows both parties to claim victory: Republicans get the extension, and Democrats get more tax income from the wealthy. While the extension of low rates will not add new spending to the economy, most people won’t pay out more in taxes. However, a failure to reach an agreement would cut usable income, spending, and consumer confidence with dire political consequences.

There will be a lot of chest-pounding and finger-pointing, but an agreed-upon tax plan will likely be reached whereby top income earners will pay more income taxes in 2013 and thereafter. Governor Romney, during his presidential campaign, floated the concept of limiting deductions to a specific dollar amount, possibly $17,000 per tax payer. While Romney’s proposal was coupled with 20% additional cuts in income tax rates (which will not happen), his proposal signaled a willingness by Republicans to accept some changes leading to higher taxes for the wealthy. Both parties get something for their supporters if they compromise.

3. Restoring the Budget to the Department of Defense

No congressman or senator wants to be viewed as soft on defense or the security of the country. The Budget Control Act automatically cuts $500 billion from the Department of Defense’s budget over the next decade, resulting in “the smallest ground force since World War II, the smallest Navy since 1915, and the smallest fighter force in the history of the Air Force,” according to Secretary of Defense Leon Panetta. The sequester cuts will eliminate more than two million jobs, adding 1.5% to the unemployment rate.

Future budgets of the Department of Defense will be affected by several factors:

  • Eliminating redundant or unnecessary weapon systems
  • Closing some domestic and foreign military bases
  • Reducing the number of military personnel
  • Requiring defense contractors to be more efficient and accountable

These actions would not compromise the security of the country.

4. Reforming Social Security and Medicare

While most details of the changes affecting both programs will not be available until later in 2013, the compromises affecting the programs are likely to include the following:

  • Elimination of the Social Security Wage Base for the Federal Insurance Contributions Act (FICA) Tax. Currently, the tax applies only to the first $110,100 of salary, and is payable by both employee and employer. It’s likely that there will be no earned income limit in the future.
  • A Return to the 6.2% Old-Age, Survivors, and Disability (OASDI) Tax Rate. While popular with the public, the current rate of 4.2% is already scheduled to increase to 6.2% in 2013. An increase in revenues is necessary to strengthen the program and ensure that the benefit will be available to future generations.
  • Delay of OASDI Retirement Benefits. People born after 1960 can receive full retirement benefits at age 67 today, an increase from age 65, as initially established in the Social Security program. Partial retirement payments are available at age 62. People are living longer today relative to when Social Security was introduced; therefore, it makes economic sense to further raise the age at which early retirement can begin, as well as the age when total benefits are available. The changes will likely be implemented over the next 25 years to assure fairness between generations.
  • Higher Rates for Medicare Parts A, B & D. While Medicare beneficiaries do not currently pay for Part A (hospital insurance) since they paid FICA while working, they pay monthly premiums for Parts B (physicians and other medical providers) and D (prescription drugs) based on their level of income. Each part requires a co-payment by the beneficiary, and has specific limits on services or products that are covered. It is likely that, similar to private employers offering health insurance to their employees, beneficiaries will become responsible for a greater proportion of their total medical costs through higher premiums and co-pays. A greater number of services, treatments, and drugs are also likely to be excluded from coverage.
  • Capitation Model in Medicare. Healthcare costs have outpaced the growth in GDP for years, leading to the controversial Patient Protection and Affordable Care Act (“Obamacare”). The extreme rise in costs also threatens the viability of the Medicare program. Republicans have proposed a replacement voucher system, effectively capping the government costs while shifting the risk of increased payments to beneficiaries. Democrats, opposing the privatization of the program, have focused on reducing provider payments to control costs. As a consequence, providers have withdrawn their services, effectively rationing the care available to beneficiaries. But neither approach affects the fundamental drivers of healthcare cost increases. Most healthcare experts agree that the long-term solution is an industry-wide payment model wherein physicians and hospitals are paid for the quality and outcome of their care (capitation) versus the quantity of services delivered (fee for service).

5. Focusing on Waste and Fraud in All Federal Government Programs

According to a Government Accounting Office report in early 2011, “Reducing or eliminating duplication, overlap, or fragmentation could potentially save billions of taxpayer dollars annually and help agencies provide more efficient and effective services.” As an example of excess, the report describes more than 2,100 data centers across 24 federal agencies that could be consolidated for savings up to $200 billion over the next decade. Members of both political parties have stated their intentions to pursue savings in areas identified in the report.

dollar bill fiscal cliff

Final Word

Our current political system is reminiscent of Aesop’s fable of the two goats. The goats lived on two sides of a steep mountain chasm, at the bottom of which roared a mighty, turbulent river. The only link between the two sides was a fallen tree, just wide enough for a single animal to pass. The height and narrowness of the passage made even the bravest animal take a longer, but safer path to the other side.

Not so the goats. Each decided to cross the log to the other side at the same time. As one took a step, the other did likewise, meeting face to face, horn to horn, in the middle. Each pushed and shoved the other to no avail, neither goat willing to swallow his pride, back up, and let his rival pass first. During their struggle, one slipped from the log and fell, dragging his rival with him to the roaring currents below. Our political parties are akin to the goats in their determination to share misfortune through stubbornness, rather than yield to common sense.

Are you worried about the upcoming financial chasm?

Michael Lewis
Michael R. Lewis is a retired corporate executive and entrepreneur. During his 40+ year career, Lewis created and sold ten different companies ranging from oil exploration to healthcare software. He has also been a Registered Investment Adviser with the SEC, a Principal of one of the larger management consulting firms in the country, and a Senior Vice President of the largest not-for-profit health insurer in the United States. Mike's articles on personal investments, business management, and the economy are available on several online publications. He's a father and grandfather, who also writes non-fiction and biographical pieces about growing up in the plains of West Texas - including The Storm.

Related Articles

The content on MoneyCrashers.com is for informational and educational purposes only and should not be construed as professional financial advice. Should you need such advice, consult a licensed financial or tax advisor. References to products, offers, and rates from third party sites often change. While we do our best to keep these updated, numbers stated on this site may differ from actual numbers. We may have financial relationships with some of the companies mentioned on this website. Among other things, we may receive free products, services, and/or monetary compensation in exchange for featured placement of sponsored products or services. We strive to write accurate and genuine reviews and articles, and all views and opinions expressed are solely those of the authors.

Advertiser Disclosure: The credit card offers that appear on this site are from credit card companies from which MoneyCrashers.com receives compensation. This compensation may impact how and where products appear on this site, including, for example, the order in which they appear on category pages. MoneyCrashers.com does not include all credit card companies or all available credit card offers, although best efforts are made to include a comprehensive list of offers regardless of compensation. Advertiser partners include American Express, U.S. Bank, and Barclaycard, among others.
Close