The Fiscal Cliff and the Debt Bomb

Much todo has been made about the Fiscal Cliff.  For those who have been in a cave for the last month, the fiscal cliff occurs at the end of the year when both the tax cuts enacted under the Bush administration in 2003 and the peanut-butter spread spending cuts enacted last summer by Congress go into effect.  This is expected to have a severe effect on the economy.

The expiration of the tax cuts mean that the tax rates will go up for everyone, since the tax rates were cut in all brackets.  There were also increases in things like the child tax credit, increases in the amounts that could be invested in IRAs, and other tax breaks that will also expire.  Probably the most important for readers of this blog is the increase in divided tax rates from 15% back to ordinary income levels.  This means that for some of the taxes on dividends will go from 15% to almost 40% – pretty tough on grandma who is living off of her investment account.

On the spending side, there are large cuts to the Defense budget.  These will hit government contractors the hardest, even though they are only a small part of the workforce, since the ones allocating the money will probably opt to let contractors go before cutting civil servant positions.  The effect on defense readiness also has been called into question by defense personnel up to the Defense Secretary himself.  Certainly increasing the likelihood of an attack and reduced national security will not be good for the economy.

The current spitting match is between Democrats, who want to raise taxes and raise spending, and Republicans, who don’t want to raise taxes and don’t want to see Defense cuts.  It is very likely that Republicans will agree to tax increases, maybe just deduction elimination for those making above a certain income level in exchange for reducing or eliminating the Defense cuts.  Democrats will declare that the increased taxes will help reduce the deficit and allow for “investment” in things like education and jobless benefits.  There will also be promises of spending cuts, but these will never come.

The fiscal cliff, however, is really not important, when compared to the debt bomb.  Unless spending is actually cut – not just cuts in the amount of spending increases planned in the future, the country will face a real problem in about four years.  The tax increases proposed are advertised to bring in about $1 T over the next 10 years.  Note that this predicts that the tax increases will not affect earnings and incomes, which is probably not the case, and that a future administration won’t just change tax rates again, which is also probably not the case.  Even if the taxes really do bring in another $1 T, however, the amount added to the debt over that time will be between $10 T and $15 T.

To put this into perspective, imagine that your family has an income of $35,000 per year and debt of $160,000.  You are spending $45,000 per year, so each year your debt increases by about $10,000.  Even though you have incredibly low interest rates, you are still paying about $4500 in interest every year, which is difficult on an income of $35,000.  It will get worse if interest rates go up, which is very likely given how much debt you have and that interest rates are currently historically low.

Now let’s say that you start selling baskets at a craft fair and start making an extra $100 per year.   You now make $35,100 per year, but you are still spending $45,000 per year, so your debt is still increasing by $9,900 per year.  In ten years, your debt will be $259,000 instead of $260,000, as it would have been if you had not started going to that craft fair.  This is exactly the effect that the increase in taxes of $100 B per year will have.  You are increasing revenues by $1 T over 10 years, but you are overspending by $10 T-$15 T over that same period.

The real debate that should be going on is what spending will be cut to eliminate the deficit within the next 3 years.  Otherwise, within 4-5 years we will no longer be able to borrow more and the interest payment on the debt will start to approach the amount spent on Social Security.  This will jeopardize national defense and all social services, including Social Security and Medicare.  Inflation may soar, wiping out the savings of those who keep their money in the bank and money markets.  This will be particularly hard on those in retirement living off of their savings.

This is the real cliff, and both Republicans and Democrats are stepping on the gas, Thelma and Louise style.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Photo credits:  Colin Broug

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