Musings at the Cliff’s Edge

Years ago, my brother worked for the Naval Air Rework Facility at Marine Airbase Cherry Point, NC. Each year he would tell us incredible stories of how the military handled surplus near the end of a budget year. One of those years he noticed some large bulldozers digging a ditch roughly 25 feet deep and fifty yards long.  There was nothing unusual about that sight, until he saw that they were refilling it with brand new diesel generators and a host of other pieces of unused, even boxed equipment. So with the books balanced, they covered them over and drove away.

In August of this year President Obama and Congress dug a massive ditch they seem quite willing to drive the US economy into. In just four days they must find a way to bridge their ditch or just drive us in. In the latter case, economists estimate that between 2% and 4% of GDP could be sapped from the US economy, which almost surely spells recession (more on that later).

Let’s first take a look at what the ditch means for those of us outside of Washington – those of us who pay the taxes our government enjoys so much burying. The following examples  come from an interactive in today’s Wall Street Journal that demonstrates how Americans, by tax-paying class, will be impacted if we sail over the cliff. I have made slight modifications for brevity.

Single Unemployed Person – Income: Under $10,000. Largest percentage tax increases. A single unemployed person making less than $10,000 would see his or her taxes rise 55.2%. Many unemployed people also face loss of extended unemployment benefits. Average tax rate under the proposal: 8.4%. Average federal tax change: Up $159, or 55.2%.

College Student – Income: $10,000-$20,000. A tax increase of 37.9%, the second highest among all singles. Big factors include loss of education breaks, as well as loss of the payroll-tax holiday. Average tax rate under the proposal: 7.5%. Average federal tax change: Up $308, or 37.9%.

Lower-Income Working Couple – Income: $20,000 – $30,000. Taxes will increase $1,423, from receiving a $15 refund to paying $1,408. Big factors include the loss of the Bush-era 10% bracket, the loss of relief from the so-called marriage penalty and reduction of the child credit. Average tax rate under the proposal: 5.5%. Average federal tax change: Up $1,423, or 9,809%.

Retiree Households – Income: $30,000 – $40,000. The highest tax increase for retirees would be 42.4%, affecting those in the $30,000 to $40,000 income range. Even very high-income retirees would see a lower percentage increase. Loss of Bush-era tax rates is a big factor. Average tax rate under the proposal: 5.1%. Average federal tax change: Up $540, or 42.4%.

Higher-Income Professional – Income: $150,000. This group, making $100,000 to $200,000, would absorb a big share of the overall tax increase, 24.7%, and would see an average tax increase of $6,662 or 24.5%. This group also would lose protection from the alternative minimum tax, originally intended to hit very wealthy households. Average tax rate under the proposal: 25.3%. Average federal tax change: Up $6,662, or 24.5%.

High-Income Couple – Income: $350,000. This group would get hit by the cumulative impact of the Bush tax cuts disappearing and AMT relief going away. Investments also would be hit by higher rates on dividends and capital gains. Average tax rate under the proposal: 29.0%. Average federal tax change: Up $13,847, or 20.3%.

Very High Income Households – Income: $1 million or more. This group’s average federal tax bill would rise $254,637, or 24.2%. Yet their share of overall federal tax would go down, because the impact of the fiscal cliff on lower earners would be so great. Average tax rate under the proposal: 39.7%. Average federal tax change: Up $254,637, or 24.2%.

One might reasonably ask what makes it necessary for our leaders to yank us around so? What drives this ditch (or cliff)  mentality, and why do they see fit to create such crises in the first place? The short of it is this: There exist two major and distinct fiscal ideologies in Washington that simply aren’t reconcilable – Big government and Small government. The Big government crowd has most of the power now and they want to spend more and tax more to enable government to do more for the people and our country, believing it best for our country.

The Small government crowd is strongly against Big government’s taxing and spending, believing that it actually weakens and eventually kills our country. The Smalls have some  power, in one house of Congress to slow the spending and taxing, but to make any gains on that front they risk allowing the automatic budget cuts of sequestration and the Democratic tax rates from the Clinton era to return if negotiations fail. They are not elegant, but at least provide a good start at reducing the government’s widening budget deficits.

So how big is the problem of government spending? David Wessel of the Wall Street Journal provides as good a summary as I have seen on the problems our government faces on becoming more fiscally responsible.  He presents five basic facts which make the problem seem almost impossible.

1. In 2011 63% of all federal spending was automatic. Congress is essentially bound to promises made by previous Congresses for Social Security, Medicare, Medicaid, farm subsidies, and previous uncovered spending resulting in debt and interest. Most arguments and press are focused on the smaller 37% that can be controlled.

2. One of every four dollars, or 25% of government spending goes to healthcare. In 1960, before Medicare and Medicaid, less than 10% of all spending went to healthcare. Government spending on healthcare, left alone (which is what we seem to be doing best), is expected to rise to 33% of government expenditures.

3. More than four million people work for the federal government. If all of them were furloughed tomorrow, we could cut the deficit by only a third. In other words, its not the studies of what a menu on Mars would consist of, or buried generators, or how many bridges to nowhere there are – these are just diversions from the real culprits, which are entitlement programs.

4. Defense. The US spent $700 billion in 2011 on defense – that’s $1 out of every five, or 20%. We spend more than the next 17 (SEVENTEEN) countries combined including China, Great Britain, Russia, Japan, Saudi Arabia, Germany and Israel, and ten more.

5. Federal income taxes as a percentage of income are falling. In 1981 the middle of the Middle Class paid 19.2% of their income in taxes. In 2007 it was 14.3% What makes up the difference? The rich pay considerably more and the government borrows the rest. In fact, the government now borrows 36 cents of every dollar they spend, or waste. Foreign governments finance a large portion of that borrowing, which makes number 4 seem more important.

The president and the four leaders from Congress are scheduled to meet this afternoon at 3:00 to try to negotiate what Messrs.’ Obama and Boehner have failed to do. It is rumored that Mr. Obama is offering the same $250K income limit for extending the Bush tax cuts while the Senate may be ready to offer $400K. If the House can get significantly below Mr. Boehner’s Plan B of $1 million, we may have the beginnings of a kick the can down the road bill to forestall the cliff. It’s a HUGE if.

Now, back to the cliff. Let’s say we drive over the cliff and the already weak economy falls into recession.  What would it look like?

It’s quite possible that things would not look that much different in a new recession than they do today, for most that is. It would be difficult to convince a large segment of the US population that the last recession really ended. We have become accustomed to living on considerably less. Unemployment remains high, income improvement for those working has been slow with home prices falling. Consumer spending has been guarded and virtually non-existent for big ticket items such as cars, appliances and furniture.

The chart above is from Bloomberg BusinessWeek and Commerce Department data. It shows that the average age of cars, appliances, and furniture owned by US households is at its highest in almost half a century. At some point these items will need to be replaced creating a wave of spending that can help sustain, even re-energize the economy.

The housing market is arguably also in recovery, which might be able to withstand the ending of the bush era tax cuts. The index of pending home sales climbed 1.7% in November to 106.4, the highest reading since April 2010.

A separate report showed business activity in the US expanded in December for a second month, despite uncertainty of the pending cliff. The MNI Chicago Report’s business barometer rose to a four month high of 51.6 from November’ 50.4, according to Bloomberg. A reading of 50 is the dividing line between expansion and contraction.

The cliff is not our problem. Runaway government spending  defended by the errant belief that big government creates a better America are the problems we face. Anyone who would argue need only look to the problems of Europe. America’s relative immunity from these ills will vaporize the day the US dollar is replaced as the world’s reserve currency.  Suddenly credit ratings on our debt WILL matter. Who owns our debt WILL matter. The strength of our military WILL matter, because we will need it to defend us from without and from within.

Suddenly the piper will demand payment and the weight of decades of political and fiscal irresponsibility, corruption, and ineptness will overcome the mighty foundation of the US economy and the “Great Experiment,” the “Shining City on the Hill” will slide over the cliff, quickly or slowly, as will be determined by other nations to whom even today we pledge our future and our treasures.

In a very poignant way, the current cliff is a wakeup call for the massive end-all cliff ahead. The last election returned a gridlocked Congress to address the massive problems we face as a country. They are problems arguably more challenging than any of America’s wars and economic disasters because we do not face them directly. They exist well (as far as Congressional terms go anyway) in the future.

Is it possible for our leadership to find a balance between the tensions of big and small government sufficient to avoid the mega fiscal cliff that awaits us? The answer is years away, not four days.

Happy New Year.