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How I learned to stop worrying about the Fiscal Cliff and you can too.

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fiscal cliff

You can’t turn on the TV or radio or pick up a newspaper these days without being confronted with scary talk about the Fiscal Cliff and the doom that awaits us should we hurdle over it into the abyss.

This is (mostly) a financial blog.  I intentionally avoid politics, primarily because that subject turns so ugly so quickly.  So I thought long and hard about whether to broach this subject.  It treads dangerously close to the political line where I simply do not want to be.  Yet, this Cliff business does have financial ramifications.  So, here goes….

Are we really going to go over this Fiscal Cliff?

Yep.

Will going over the Fiscal Cliff be the disaster we’ve been lead to believe?

Depends on how you view our nation’s (the USA for my international readers) debt and deficit.  The greater these problems are in your mind, the better going over the Cliff will be.

How can going over the Fiscal Cliff be a good thing?

Well, you need to understand the two things that will happen.  One, the Bush-era tax cuts will be allowed to expire.  That means a tax increase for everybody and more revenue for the government.  Two, dramatic across the board spending cuts will automatically take effect.  This will lower government spending.  Both these things will happen on a scale unlikely to be accepted by either party thru negotiation.  This great scale of increased taxes and reduced spending will have the greatest possible impact on reducing our debt/deficit.

Gee, that sounds great!  What’s the problem?

That depends on who you are.  If you benefit from a program that gets cut, you probably won’t like it.  When you have to pay more taxes, you won’t like that either.  Oh, and some economists think the combination of reduced spending and increased taxes could trigger a recession.

But our politicians will reach an agreement and save the day, right?

Could happen.  But my bet is we’re going over.

But why?

Because to reach an agreement would mean both sides will have to take something, tax cuts or spending programs, away from their constituents.  That’s something no politician likes to do and few have the stomach for it.  Plus, both sides win by letting us go over.

Both sides win?  How’s that?

These are smart people.  Both sides know that we need to cut spending and increase taxes.  Both happen when we go over the Cliff.  When we do both sides can blame the other for not coming to an agreement to avoid it.  Plus, then they can get back to doing what they really like to do.

Doing what they like to do?  What’s that?

Why giving stuff to their constituents, of course.

Ah, OK.  How’s that work?

Think of it this way:  Going over the Fiscal Cliff is essentially hitting the big Reset Button.  Taxes spike up and spending programs across the board get slashed.  Both happen more dramatically than anyone really wants or needs.  So now the politicians can get to work restoring the favored tax cuts and spending programs that have the broadest support.  In the process, they get to look like heros.

Now I get it…

Right.  Instead having to explain why they raised your taxes or cut a program that provided jobs in your city, they can tout how they cut taxes and increased spending on those critical programs we all love.

Wait!  Doesn’t that get us right back where we started?

Not immediately and not if they’re smart about it.  This will be a great opportunity to leave those tax increases and program cuts everybody really wanted in the dust without having to take any responsibility for them.

Wow.  These guys really got lucky the way this is going to work out.

Lucky? Maybe not so much.  Remember, these are the same folks who designed and created the Fiscal Cliff in the first place.

Warning:  As always I encourage and welcome your comments.  But anything remotely touching on partisan politics, either side, will be deleted.  This is not the place.

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Comments

  1. I have an idea to make both sides happy — enact fair tax(no tax increase) and drill gas all over this great nation(more revenue). It’s not that hard 🙂

    Reply

  2. Yes, sooner or later the fan blades will be bent. Something hit the fan blades. They can be straightenened, and the smell will go away. Great post.

    Reply

  3. Good day.I have just finshed your succint view of the Fiscal Cliff. Living in South Africa you may wonder why it matters to us? When the US is unwell, economically speaking, we ourselves start to show symptoms of illness. These symtoms appear in our falling mineral exports, worsening exchange rate if the rates in the US rise and early signs of economic pessimism.

    We hope that even if the US does go over the edge that the remedies (negotiations) occur sooner rather than later to ensure that those who appear unconnected to the US do not end up in intensive care.

    Irrespective of the varied world opinions on the US everyone needs the US to be flourishing and vibrant.

    Reply

  6. Hi Jim,
    I really enjoyed this calm and reasoned approach to the cliff, I for one, have had my fill of useless hand wringing and teeth gnashing.
    Still you leave me with a question, now that you’ve it worked out what is likely to happen, what are you going to do about it? Are there any specific changes that you intend to make to your financial plan to take advantage of or mitigate the circumstances?

    Reply

    • Thanks Cassie…

      Glad it resonated. After this passes, the media will have something new to get us uselessly wringing our hands and gnashing our teeth.

      What am I going to do? Nothing.
      What changes to my financial plan will I make to mitigate? Zip.

      The strategies we discuss here are for long term success and are designed to weather far bigger events than this.

      Reply

  7. I appreciate your bold stance here. As much as I personally would like to see us hit that big reset button to get a handle on our deficit spending, I don’t think it’s going to happen quite like you have outlined. See, our political leaders love to be in photos above headlines proclaiming last-minute success. For about 360 days/year, their main goal is to obstruct the other side. But when it comes down to crunch time, they like to be able to point to a case where they were instrumental in bringing together leaders from both sides to do what’s best for the country. So I envision something more like the game of chicken that was played with the debt ceiling recently. I predict some of the current taxes and deductions will indeed go over the cliff, but the favorites of each side will make it through. So it will be a hybrid approach. Then in 2013 further changes will be made to try to salvage the items that couldn’t be saved at the last minute in 2012, just like you described.

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  8. Hi Jim,
    I guess I do worry about this fiscal cliff. I would love my dh to retire now-we do have over 1 M in investments but with four kids still at home, it feels like such a leap. Enjoyed your article especially the picture!

    P.S. I listed my alia name below but since I emailed you privately last spring, I hope you remember my real name.

    Reply

  9. Jim, I really like your reasoning in this article. Your perspective is different from some of the other articles I’ve read on the subject but your predictions seem realistic.

    I have some cash that I was planning on investing soon so I’m going to be watching closely. I try not to time the markets, usually, but since the markets hate uncertainty, I’m not pulling the trigger just yet and will instead wait to see if I can get any bargains in the after-Christmas sales!

    Reply

    • Yeah, I’ve been debating on whether to give the old portfolio a cash injection as well. Uncertain market conditions (and a potentially over-priced market) make you want to wait and see. Also, not sure if I should invest the whole thing at once in these conditions or dollar cost average it in. Any thoughts from JLC or MF on what you’d do with a large amount to put in (say $100k ish)?

      Reply

      • I’m not a fan of DCA (dollar cost averaging). Basically it screws with your allocation: too heavy in cash in the early stages.

        If the 100k you plan to invest is going in for the long-term, the only way to invest IMHO, I just pull the trigger. 20 years from now any minor price difference will be long forgotten.

        Truth is prices could be lower in January. They could as easily be higher. No one can know.

        One reason to wait, if you are investing in a taxable account, is that these funds payout dividends and capital gains in December. If you buy just before they do, you are picking up a tax liability. Better in that case to wait.

        Reply

  10. The only thing that’s been demonstrated in Washington these past few years is an inability to negotiate and compromise. If/when the fiscal cliff happens, each side will point fingers at the other side and tell their supporters they tried to fix things but the other side wouldn’t listen. They are all a sorry lot in my book.

    Reply

    • they may be a sorry lot in Washington but they make me even sorrier. look at the net worth of those who are supposed to represent us…they are mostly millionaire lawyers….so they behave pretty much the way one would expect that group to behave…badly.

      Reply

  11. its really not fair to just write that increasing tax rates automatically means more tax revenue. thats not an assumption you can make, and a big reason why a lot of people fear the fiscal cliff. i would recommend talking about the Laffer curve to describe this conundrum.

    http://en.wikipedia.org/wiki/Laffer_curve basically, the higher people get taxed, the less likely they are to spend, more likely to save (less money being taxed) and there is less incentive to work to more (less money being made to be taxed). so higher tax rates not only have diminishing returns, but start losing out on the amount they can aggregate.

    Reply

    • OK Brandon….

      Your comment treads dangerously close to my “no partisan politics’ line. I say that because your description of the Laffer Curve displays a lack of understanding as to what it is (and that’s fine) or an attempt to use it to make a political point.

      In fact, the LC does not say what you seem to think it says. It is a theoretical concept that says there may be be a point where higher taxes discourage productivity. The result of crossing that line could result in a reduction of actual revenue raised. The problem is there is no consensus as where that magic point is or to how to draw the curve.

      Were you to draw it as a simple, classic symmetric bell curve that would suggest that tax rates above 50% become counter productive. But there is no reason to believe that this is the correct way to draw it.

      You could just as easily draw it with the peak at a higher or lower percentage. You are making the assumption that current tax rates are at that tipping point and from there you assert higher rates would have diminishing returns.

      While the LC provides a framework to think about the subject, in and of itself it offers nothing to support your conclusion.

      To quote your source:

      “The Laffer curve is typically represented as a graph which starts at 0% tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate. The actual existence and shape of the curve is uncertain and disputed.”

      Not even Laffer claimed he could draw his curve definitively showing where that perfect rate/revenue balance might fall. Indeed, partisans on both sides have chosen to draw it in whatever fashion they prefer to score their own political points.

      All that said, the source you linked to is a good one. I suggest any readers seeking to understand LC in greater depth give it a read.

      Reply

      • of course its near to impossible to determine the point at which we would reach the peak of the laffer curve, but i was merely pointing out that you stated the tax increases in the fiscal cliff would in fact raise tax revenue, which is not known for sure. it would definitely hold true if everything else in the economy were to hold constant, but there is always a butterfly effect, where 1 small change (or big) changes many others. i stated that was why some people fear the fiscal cliff. not making any political statements, just explaining the POV some have in regards to fear of the fiscal cliff. granted we could be anywhere currently on the laffer curve (be it on the downward slope, upward slope, or even at the peak), so tax rate increases or decreases could result in either tax revenue increases or decreases.

        i have a very clear understanding of the laffer curve as i majored in economics in college. i was not making a single assumption, i was just pointing out yours, which is that you think we are on the left side of the curve, where tax rate increases would definitely result in tax revenue increases. “That means a tax increase for everybody and more revenue for the government.” which is fine to hold that opinion. i didn’t state my opinion at all, i simply stated that you can’t be sure that revenue would increase from increasing tax rates, and i attempted a simple explanation of the reasoning behind the LC that readers may want without having to read that entire wiki article. you decided to make claims i was being political and insult my intelligence regarding the laffer curve.

        i do enjoy most of your articles, but come on. nothing i said was politcal and nothing that wouldn’t be taught in an econ101 class.

        Reply

        • No insult intended, Brandon, and I appreciate your kind words regarding my articles. “Most” of them anyway. 🙂

          I just went back and reread your original comment, especially the second paragraph. As written, it still suggests a lack of understanding or an attempt to make a political point.

          Your reply above makes your position and intent much clearer. Well within my requested guidelines and appreciated for it. But initially I had only your original comment to work with. My choice was to simply delete your comment or to assume the best and use it to expand on the subject of the Laffer Curve which is a good one in the context of this conversation.

          It is also possible that I’m a bit too vigilant on the ‘no partisan politics’ policy.

          In any case, I’m glad you weighed in and hope you stick around.

          Reply

          • I only say “most” because I’m relatively new to the site and haven’t had the chance to read them all yet :). Glad to contribute. Wasn’t trying to stir anything up. Thanks for the responses.

          • Exchanges like this are why I absolutely love the blogosphere and also why I barely ever turn on the television anymore. I learned more in the two minutes it took to read this comment string than I would have ever gotten in an evening full of 30 second sound bites on any cable news channel. Thanks.

          • Thanks Joe!

            I really appreciate you weighing in.

            My sense is that lots of readers skip over the comments. Maybe that makes sense on other blogs, but here I remain impressed with the calibre of contributions from my commentators.

            Some of the best material here is in the comments. Glad I’m not the only one who thinks so or who sees them! 🙂

  12. Hey Jim! Glad you did a post on this. Will going over the cliff affect the stock market in any direct way? Thanks for your input and thorough explanations 🙂

    Reply

  13. I’m not too happy it was written in in the first place. I don’t know if that’s a political statement. Sorry if it is. Thanks for lying this out so simply. Hopefully some of it will be fixed by tax season….might be selfish and nationally fiscally irresponsible, but I really don’t want to pay anymore. My city alone takes enough from me. (Our tax rates are 3x what our state takes.)

    Reply

  14. This is the first time I’ve read anything about this topic – thanks for the sane summary – it will be interesting to see how it plays out.

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  15. Great stuff and I agree 100%. Thanks for laying this out succinctly and fairly.

    I haven’t written about this, but if I were to I would express the same opinions as you.

    Spending cuts are necessary and so are revenue increases. The government can’t keep this kind of ledger forever. If it comes way of negotiations (unlikely), then that’s fine. If not, the cliff ensures action.

    The cliff or lack of cliff hasn’t impacted my investing decisions whatsoever. I’m still buying shares in high quality companies for the long-term and I can only hope that the market reacts negatively to whatever news pipes out of Washington, which would provide me better long-term entry points on my favorite companies.

    Best wishes!

    Reply

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