Download Thought for the Week (229): The Fiscal Cliff

Thought for the Week (229):
The Fiscal Cliff
Now that the Presidential Election is over, our attention turns to the next major factor affecting the outlook
for stocks, bonds and other investment asset classes: The Fiscal Cliff.
What is the Fiscal Cliff?
The Fiscal Cliff is the term used to describe the meeting of two events at the end of 2012:
1. The expiration of almost every tax cut enacted since 2001 and
2. A reduction in government spending first proposed during the 2011 Debt Ceiling Crisis called the
Budget Control Act of 2011.
These measures were designed to help balance our budget deficit; however, if enacted, they will more
than likely begin to slow the U.S. economy.
The Federal Reserve Board Chairman Ben Bernanke defines the Fiscal Cliff as the many major fiscal
events that could happen simultaneously at the close of 2012 and the dawning of 2013. These events
include the expiration of the Bush era tax cuts, the payroll tax cut and other important tax-relief
provisions. They also include the first installment of the $1.2 trillion across-the-board cuts in domestic
spending and defense programs required under last summer’s deficit reduction agreement. At the same
time, lawmakers may have to raise the debt ceiling once again, potentially triggering another standoff in
Congress.
The Tax Provisions that will expire on Dec. 31st, 2012, should we fall over the Fiscal Cliff include:

Changing the current individual tax rate brackets (10%-15%-25%-28%-33% and 35%) to the pre2001 rates of 15%-28%-31%-36% and 39.6%.

Returning the tax on Long term capital gains and Qualified dividends from 15% to 20% and
39.6%, respectively, and the return of the limitation on itemized deductions and phase out of
personal exemptions.

On January 1, 2013, several provisions that benefit the lower classes, including the increased
Child tax and earned income credits and the expanded education credits, should expire.

The Estate tax exemption and tax rate are currently at $5,120,000 and 35%, respectively. Come
January, they will return to $1,000,000 and 55%.

The AMT exemption for 2011 of $74,450 for married couples filing jointly will reset to $45,000,
pulling tens of millions of taxpayers into AMT.

For 2011 and 2012, the employee’s share of Social Security tax was cut from 6.2% to 4.2%. This
rate cut expires at year end.

Starting in 2013, taxpayers earning more than $250,000 will pay an additional 0.9% tax on their
wages and 3.8% on their unearned income (interest, dividends and capital gains).
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.

There are a host of provisions set to expire at year end that regularly do so; usually Congress
retroactively saves them. Foremost among these provisions are the R&D credit and the personal
deduction for state and local income taxes.
If all these tax increases and spending cuts take effect; the grand total being in the region of $7 trillion
over a decade, the government could save nearly $600 billion starting next year. However, the same
measures would reduce U.S. GDP by an amount which may plunge the economy into recession. As a
result, the slow but steady economic growth of the last three years may be replaced by contraction.
Is it better to Cut or Spend your way out of Debt?
So here’s what we are facing. If the politicians don’t come to an agreement, all tax rates will return to their preBush Tax Cut levels. In addition, discretionary spending and defense spending will see deep cuts, meaning an
increase in government furloughs and layoffs, which will feed right through to the unemployment numbers.
Doing nothing will result in our debt continuing to grow and therefore our credit rating may suffer. "Failure
to avoid the fiscal cliff and raise the debt ceiling in a timely manner as well as securing agreement on
credible deficit reduction would likely result in a rating downgrade in 2013," Fitch Ratings warned. If left
in place, the Fiscal Cliff would lead to the biggest single-year drop in the annual deficit as a percent of the
economy since 1969.
We are therefore facing a situation where the obvious way to reduce the Government’s debt and deficit is to
cut spending and increase taxes. But the economists are telling us this will make the situation worse. For
them, a better way out of the predicament is to grow the economy.
It looks like the Administration is caught between a rock and a hard place.
Political Machinations
So, what’s the big deal? Can’t the politicians agree to defer most of the Fiscal Cliff measures and keep
the economy on its slow recovery path? After all, when the ratings agencies lowered our credit rating last
year our Government treasuries went up, not down, in value.
For decisive action to occur, the President and Congress must quickly come to an agreement on whether
to leave the Fiscal Cliff measures in place, replace some or all of them, postpone them or cancel them
entirely. Their decision will affect the U.S. economy, the country's credit rating and the U.S. debt burden.
Unfortunately, consensus between the White House and Congress doesn’t always come easy. Although
we feel an agreement will ultimately be reached, markets hate uncertainty and we are currently expecting
a period of brinkmanship and bargaining prior to a mutually acceptable settlement.
With a clear electoral mandate to pursue his policies of reducing the deficit by taxing the wealthy, we
would expect President Obama to defend this area of the Fiscal Cliff.
That said, he obvious next step in the negotiations would be a swift and bipartisan agreement to defer
everything for three to six months, giving both sides ample time to construct a deal that works for all three
parties: Republican, Democratic and the Economy!
In the meantime, we continue to hold high levels of cash and position our portfolios to weather a
politically-inspired correction. When the opportunity to pick up discounted, quality investments presents
itself, we will be ready with cash to invest.
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
The Congressional Budget Office (CBO)
The Congressional Budget Office is the nonpartisan government agency that provides economic
information to Congress. In their opinion, the Fiscal Cliff will cause the economy to contract but it will also
put the federal debt on a much more sustainable path.
The charts below outline their longer-term projections of the effects of falling over the Fiscal Cliff or,
alternatively, allowing the extension of most tax cuts and spending policies.
Clearly, doing nothing and allowing the Fiscal Cliff, the left-hand column, to happen will reduce the
annual federal deficit by approximately one half of one trillion dollars! The broader economy will have to
find a way to cope with the Cliff but at least the deficit will be improving.
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
The following chart shows the CBO’s deficit projections over the next ten years. The “Baseline” bar is the
CBO’s projection of the deficit should nothing be done to change the provisions in the Fiscal Cliff.
The additional bars in this chart provide an estimate of the deficit levels resulting from a continuation of
current policies, i.e. preventing the Fiscal Cliff.
The final diagram, below, illustrates a few more effects of the Fiscal Cliff or Alternative Scenario in 2013.
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.