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What the 'Cliff' Compromise Means for the US Economy

VIDEO: Congress' last-minute deal cut the so-called fiscal cliff in half, lessening economic headwinds in the short term, but much work remains to address longer-term debt and deficit issues

Jason Stipp 3 January, 2013 | 9:03AM

Jason Stipp: I'm Jason Stipp for Morningstar.

Congress was able to come to a last-minute deal to avert most of the fiscal cliff, at least some of it temporarily, but what's still left to do? There is plenty of work.

Here to offer his insight is Morningstar director of economic analysis Bob Johnson.

Bob, thanks for being here.

Bob Johnson: Nice to be here.

Stipp: Congress did manage to get to a last-minute deal to avert a lot of what was in that original fiscal cliff. Let's first talk about the things they removed from the cliff that won't be headwinds on the economy in the next year. There are a few items they managed to get done.

JohnsonYes. The unemployment extension, they left that in there. They felt that maybe there were people who were going to suddenly have nothing … as many as 2 million people, and they decided maybe that was a little bit too much. So, they managed to extend the unemployment, so that disappeared from the cliff.

[Tax cuts for the non-wealthy] got extended. That was the biggest worry about the fiscal cliff, and I always projected that was never, ever going to happen, and it did not. So that was removed from the cliff.

Medicare payments to doctors, which is always in debate every year, we didn't go over the cliff on that.

The alternative minimum tax: They actually I think fixed that one permanently. I think they put the number in there and put an annual inflation rate in there. So, the AMT, which was a huge part of the cliff for both 2012 and '13, went away [for the large group of taxpayers who would have been susceptible without fixing the inflation patch].

So, they took the worst of the stuff out of the cliff.

Stipp: And there was also some business tax credits that they removed from the cliff, and those will still stay in effect, but not necessarily forever?

Johnson: Yes. My quick reading of the numbers we got from the CBO was, it looks like it's a one-year extension on [items] like the R&D tax credit. There are a number of, for lack of better words, corporate welfare-type tax breaks that were in there that are very popular individually. Who doesn't like R&D? And they are very popular, and they total a fair amount over a full year--maybe $85 billion--and they've extended every one of them, kind of across the board, for one more year. And some they actually parcelled out, a very small group, energy [tax credits] they parcelled off for permanency.

Stipp: So, those business leaders can now depend on those at least for the next coming year, but there's still going to be some uncertainty as we approach year-end about whether these will get extended or not. So, it increases the visibility a little bit, and potentially the confidence a little bit, for businesses, but not indefinitely into the future at this point, in most cases.

JohnsonAbsolutely.

Stipp: So, these were things that were going to go into effect [on Jan. 1] that are not going to go into effect as part of the fiscal cliff because of this deal that they reached.

But some things they didn't reach a deal on--they kind of kicked the can a few months down the road--and other things they allowed to just expire. So, let's talk about what's still in the smaller cliff--maybe it's more like a fiscal hill or a steep fiscal hill at this point. What's still in there? What didn't they address yet? And what did they allow to just go ahead and expire?

JohnsonWell, let's set a little bit of a framework, and I'm going to use the Congressional Budget Office numbers. I've used some other ones that are a little bit more annualized, but let's start with the fiscal numbers that are from the Congressional Budget Office.

The original cliff as they saw it, excluding any effects on the economy that self-feed, they said $600 billion was the amount of the cliff. And now they're saying the cliff is only $300 billion. So, they've really cut it in half.

A way to think about the $300 billion that's left on the cliff, we took away the payroll tax, which amounts to about $110 billion.

Stipp: [You mean] the payroll tax credit or the payroll tax cut...

JohnsonRight.

Stipp: … that was put in place during the recession, so that's gone. So, people will be paying higher payroll taxes on Social Security.

JohnsonAbsolutely, everybody across the board, no exceptions, 2% more in that nasty payroll tax. That's part of the cliff we went over, and that will impact spending in the next year ahead. That's a dollar-and-cents number that affects everybody at the bottom of the curve and the upper end of the curve, so it's a big deal.

Stipp: So that was the first one, so they let that payroll tax holiday expire.

The second one is that taxes did go up on wealthy individuals. What does that account for as far as the smaller cliff?

JohnsonThere are a lot of numbers that kind of get mixed together in the last-minute parts of the deal, but they think that now the taxes will go up by about $100 billion, approximately, on the wealthy--and also the estate tax and a couple of other things--will get about $100 billion with those increased taxes in year ahead according to the Congressional Budget Office.

Stipp: And originally Obama was looking [to raise taxes] for [those earning] $250,000 and up, and [the income threshold] ended up being more like $400,000 to $450,000. Those folks earning that amount will pay more in taxes in that particular group, and it amounts to about $100 billion you said.

And the last one is the spending cuts, the sequester, and they kind of kicked that down the road a little bit, but that's still technically part of this smaller cliff now?

JohnsonYes. That's definitely part of the cliff. What they've done is they've said, OK, for two months we're going to put off this sequester; we'll deal with this later. And so, technically it's on the books. It got pushed, so there will be two months where we don't have sequester the money--January and February--but then as we get towards the springtime again, that money is still technically sequestered.

So, we're looking at $300 billion in total items [left] in the cliff--if we've put the sequestration aside, its $200 billion.

Stipp: So, we don't have certainty on how much will be sequestered; they're still going to be negotiating over that. If they don't do anything and that goes into effect [as is], that's going to amount to about another $100 billion that's going to be part of that cliff that we'll see later this year, or earlier this year in the March time-frame.

So, the next question, then, if we cut the cliff in half, essentially, it's good for the short term, the market seemed to like it, we didn't have to take all that medicine at once, but I think there's broad agreement that we do have to take some medicine as an economy to help our budget, to help the deficits. So, at the cliff size it is now, is it enough in the longer term, in your opinion, or do we really need to reach that whole fiscal cliff level, but ideally not over just one year?

Johnson: I've always said, the original cliff was $600 billion to $700 billion, depending on how you measured and what time-frame, per year, and if we really did all of that, it would solve most of our short-term budget problems. As I've said, if we let everything that's in [the smaller cliff] now [occur], it's about $300 billion, and so we need to somewhere over the next three years find $300 billion of increased taxes or decreased spending to bring us back into the balance again.

StippBut if we do that over time, hopefully it won't kick us back into recession like it would have if we'd allowed it all to happen in 2013?

JohnsonRight now, we're in kind of the sweet spot. The $200 billion [cliff] which we're sure of--the payroll tax cuts and the higher taxes on the wealthy and the estate taxes--and then it's $300 billion if you include the sequestration in there. So, we can live in that range of $200 billion to $300 billion; we have before.

StippWithout going into recession.

JohnsonWithout going into a recession.

 

StippBut we'll need to find some more ways to raise revenues or to cut spending, and it looks like a lot of it might be on the spending cut side now--although Obama also said he wasn't going to just do spending cuts. But they still have to find that money somewhere for the longer-term picture of the health of the economy.

However, even if we did the whole fiscal cliff and allowed those spending cuts to happen and those tax increases to happen, that doesn't put us in a good spot forever; we're still going to have to deal with budget issues in the next 15 years or 20 years, right?

Johnson: The tricky thing is that, OK, this package gets us a little bit toward where we need to be, and if we have some more tax or spending things happen in the next year, we're probably OK, but then you get into trouble again the mid-2020s when the Medicare and the Social Security problems really creep in.

And here's the real rub: We look pretty good as a percentage of income through the mid-2020s, but then if we wait and let it go that far, then we have to do really drastic things. I don't know the exact numbers, but if the retirement age was 66, and maybe [raising that to] 68 would cure a lot of the Social Security problems [if we made that change sooner], but if we let it go all the way to 2025 [without raising the retirement age], then the number has to be more like age 70, or even worse, to fix the problem. And that just gets dire.

And so it's one of those sleeping things, where the overall numbers kind of look OK [now], but you really get into a deep problem if you let it go to the very last second, because then you have to do some pretty draconian things.

StippSo, if we can take a little bit of medicine along the way we won't have to take a big gulp of really painful medicine in the mid-2020s--if we can just figure out a way to start to make some efficiencies in the meantime?

Johnson: Correct.

StippBob, thanks for joining us again and helping us make some sense of the fiscal issues that, unfortunately, still are ongoing for us here. Thanks for joining me.

Johnson: Thank you.

 

StippFor Morningstar, I'm Jason Stipp. Thanks for watching.

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About Author

Jason Stipp  is Editor of Morningstar.com, the sister site of Morningstar.co.uk.