Solutions To The Fiscal Cliff: Time To Start Investing?

Fiscal Cliff Of Santorini, GreeceEverybody is worried about a fiscal cliff, so what the hell is it? In a nut shell, Bernanke coined the term in Feb 2012 as a way to describe massive spending cuts and tax hikes in January 2013 if there is no budget deal in Washington DC. Because the House is still controlled by the Republicans, and the Senate is still controlled by the Democrats, there is worry no legislation will pass given what happened during the debt ceiling debacle.

If no budget resolution passes, here’s what happens: 1) Federal income tax rates increase for those in the 33% and 35% tax brackets as the Bush tax cuts expire, 2) the payroll tax holiday disappears, 3) federal unemployment benefits completely vanish, 4) reimbursements get reduced to Medicare doctors, and 5) the debt ceiling stays the same, which forces across-the-board government spending cuts, including slashes in defense spending.

The fiscal cliff could amount to some $7 trillion worth of tax increases and spending cuts over a decade. This would do wonders to balance the budget to the dismay of free-spending politicians everywhere. The problem with such budget balance awesomeness is the abruptness by which policies are implemented. Even though ALL of us have known about the fiscal cliff for years, no policitian is willing to do anything until the last moment…. or more importantly, until they win the November 2012 elections to ensure power for the next four years!

I know I sound cynical about politicians, but open your eyes already! We work for the politicians, not the other way around. It’s our job to work as much as possible to keep our politicians in power so they can live great lifestyles and make lots of money while telling people what to do. Every single politician has told me, “Screw pension reform, because that’s my money!” Sweet.

Let’s address some key bickering points.

POINTS OF FISCAL CONTENTION 

* Tax the rich! Even though the top 10% of income earners who make 46% of total income pay 70% of all taxes, Democrats want to tax them even MORE! Isn’t paying 24% above your fair share enough of a contribution already? What happened to equality in America where everybody pitches in to help our great nation? Meanwhile, the bottom 50% of income earners account for 12.75% of total income, yet pay only 2.7% in total taxes.

I think most Americans do not mind the bottom 50% not paying federal income taxes because many of them earn under $20,000 or are elderly. What Americans DO MIND is the bottom 50% voting to raise taxes on the top 50% when the bottom 50% don’t have to pay any more taxes themselves! If we are going to impose our will on others, we should at least pitch in ourselves.

 

President Obama thinks taxes should go up for individuals making over $200,000 and couples making over $250,000. For some reason, President Obama thinks the cost of living in all of America is the same. The large majority of people who make over $200,000 a year live in expensive areas which dictate such high income levels! Not recognizing cost of living adjustments is going to doom budget talks. Every citizen in American, Democrat and Republican understands that $200,000 in North Dakota is different from $200,000 in New York City, except for our politicians.

Solution: Simply have different income levels for taxation hikes for different regions of the country. It doesn’t have to be super complicated. We can have three categories for living expenses: 1) Average Cost, 2) High Cost, 3) Extreme Cost. For average cost areas of the country, taxes can go up for those making above $200,000 a year. For high cost areas of the country, taxes go up for those making over $500,000 a year. And for those in extreme cost areas, taxes go up for those making over $1 million a year. Democrats will show a compromise and an understanding of reality, and the tables will then turn on Republicans to accept the federal income tax hikes. If Republicans don’t, they are the ones to blame for the fiscal cliff, because no other compromise will happen!

* Long term capital gains and corporate tax hikes. President Obama insists on increasing capital gains tax for couples earning over $250,000 to 20% from 15%. Partly as a result of this expectation, you are seeing a heavy off loading of long term gains in 2012 to save on a 5% tax increase in 2013 if Obama gets his way. Selling a stock due to paying 5% more taxes is pretty stupid if you believe in the long term fundamentals of a company. However, the stock market is all about selling and buying at the margin to move shares, and that is what people are doing.

Those who are willing to invest long term in our country’s companies are the ones who help make our economy run. Low capital gains tax compared to income tax is the government’s way of encouraging more people to invest. Sell within a year, and any gains will be taxed at your normal income rate. A 20% rate hurts lower income investors the most because lower income earners pay less than 20% federal income tax already! A 20% rate also hurts higher income tax investors because of the devaluation of stock holdings as an investment given the higher associated cost.

Solution: Since raising long term capital gains tax hurts poor and rich investors alike, America should adopt a NO capital gains tax initiative that exists in countries such as Hong Kong and Singapore. No capital gains tax will cause a huge rush of investments into the stock markets and bond markets and create more wealth, confidence, and jobs for everyone. No more do people have to endure sub 1% savings rates and sub 2% long term CD rates! Keep corporate tax rates at 35% and close offshore loopholes. Raising corporate tax rates reduces net profits, lowers market caps, and ultimately results in less hiring.

* Spending is out of control. Despite all the tax increase measures, the main issue here is reducing spending gradually to get our budget back in the black and avoid a recession in the process. Of course we cannot suddenly cut off millions of unemployed people from receiving federal unemployment benefits if we want to help employment. Of course we cannot suddenly stop forgiving the income tax homeowners have to pay on the portion of their mortgage that is forgiven in a foreclosure, short sale or principal reduction if we want to help housing. We need to clear the inventory to start fresh.

We can raise taxes on the top 10% to 100% of all income, and it would still not do anything meaningful to balance the budget. If we raise taxes on capital gains to 50%, the stock market would collapse and there would no longer be as many people earning over $200,000 a year to tax either!

Solution: There is no other way to balance the budget but to reduce spending on defense, social security, and medicare. We also badly need pension reform by Federal and State employees as we can no longer afford such long term entitlements. The private sector has more or less done away with pensions by forcing employees to save for themselves with their 401K and IRAs. Why can’t the public sector at least chip in for 50% of their retirement benefits when the private sector is contributing way more? The reason: politicians are part of the public sector, and they aren’t willing to sacrifice their own benefits!

The full age for social security benefits for anybody under 50 years old needs to be raised from 67 to 72. Hopefully nobody under the age of 50 is depending on Social Security in retirement because you are doing everything you can to save and build multiple income streams. Do we really need such massive defense spending? This might be the case of “yes we do” once we are attacked. But, surely, we can remove several billion dollar nuclear submarines off the spending list. As for Medicare, such is the way of old age, health, and dying. Here’s one area where we probably should leave alone for the love of humanity. We’ll all get there one day.

INVESTING AHEAD OF THE FISCAL CLIFF

Hopefully most of you took a lot of money off the table after QE3 was announced and are cashed up looking for buying opportunities. The markets have since sold off by over 6% as everybody is worried about politics and Europe AGAIN. Please do your best to limit your CNBC watching to 10 minutes max a day. You will literally get dumber watching because they always bring in the most bullish person after a huge runup, and the most doomsday person after a collapse.

We shouldn’t worry about the fiscal cliff because no politician wants to be blamed for another recession. The more the market drops, the more pain we ALL feel, which makes the Obama regime more careful in imposing anti-capitalistic measures. It is reasonable to conclude nothing will get done during a lameduck Congress before new politicians come to power in 2013. The good thing is, doing nothing is the base case scenario with each downtick. As a long term investor, you need to consider putting your sideline money to work. Any type of pre-2013 budget agreement by Congress will send equities soaring. No agreement just means more of the same, which is what the market is expecting. If our politicians prove to us once again they can’t get anything done, we need to all riot!

As fear gets deeper, I’m putting my money to work in energy, housing, precious metals and mining, and technology. I’m also buying a Russell 2000 structured note which provides a 10% downside buffer, and guaranteed 25%-50% upside over 3.5 years if the index is positive by even just 0.1% during this time period. Finally, I’m making loans in my peer-to-peer lending account in anticipation of all my long-term CD’s rolling off.  Everybody’s risk tolerance is different. Stay ahead of the curve and start doing your research now before the markets rebound again.

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Photo: My Santorini Cliffs, SD.

Regards,

Sam

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    We’ve cut back about 40% of our monies that are in retirement accounts and they’re in cash, although that is increasing since I also lowered the amount of my 401k that is automatically invested in any given mutual fund that we have available to us (less than 50% of my contributions and my employers contributions are being put into a fund).

    Your thoughts on making the limits on taxable income limits being dependent upon your local area could be okay, with one caveat: the tax code would have to be vastly simplified from it’s current state FIRST.
    The other side-effect of that would be less people would be actually living in the higher paid areas so that they would have more money available in less costly areas. Of course, this occurs nowadays too, but that might prompt more people to shift out of the major cities which have a tendency to require more monies to live within their boundaries … especially when there’s an additional tax for those that work/live within the city limits, like is currently done in Philadelphia, PA. :-(

  2. says

    You know Sam you make it simple and sound so easy which it could be. But you know as well as I know that the government is to busy fighting one another that they don’t do the simple things for the easy wins. I like the plan you suggest but it would never happen. I am starting to pick my investing back up again as everything is on sale with stocks. I want to put more into prosper as well and see how that goes.

    200k in a small town in SC is like living like a million vs living here in South Florida.

  3. Michael says

    Heard. And acted. QEInfinity was enough of a wake up for me to very closely analyze my holdings and adjust my risk tolerance. I moved basically everything into cash/cash equivalents, and then slowly picked a few areas to dip my toe into.

    Before you had mentioned it I was looking at the Vanguard Precious Metals fund (VGPMX) and the Vanguard Energy fund (VGENX) and I’ve slowly eased into positions in each of those. I actually increased my position in the short-term corporate bonds fund I was in, mainly because of its fairly steady stream of interest/dividend payments. But largely, I’m in cash equivalents, in the largest proportion they’ve ever been in my portfolio.

  4. says

    To your point about taxing the top 10% at 100% – I’ve heard it stated more than once that you could not only do that, but confiscate all of their wealth as well and you would only have enough money to run the federal government for about a month!

  5. says

    I’m rolling over my 401k and my timing isn’t that great. I guess I should have done it a couple of months ago. At least I got most of my investment converted to cash before the election was done. I’ll add more bonds and alternatives and see how the market goes.

  6. says

    Someone pointed this out to me recently, the cost of living thing. It IS weird that our taxes, which are really complicated, don’t go one step more complicated and take into accoutn where people live. $50K in a big city doesnt’ go as far as $50K in the middle of nowhere!

    Knowing waht the fiscal cliff is… well, seems like we shoudl go off it. We’re so imbalanced right now anyway, seems like higher taxes and geovernment cuts coudl even us out a bit. Which I think our country needs. Of course that sounds great, but no one wants to actually be affected, lol.

  7. Travis says

    I like your points except for the tiered structure for high income earners. Why should someone in South Dakota or Utah help subsidize the living expenses of someone in New York or San Francisco? If someone wants to live in San Francisco, that is their choice. They are choosing to live in a state with a high income tax (that is going even higher), high sales tax (going higher), high property values, high property taxes, high utility rates, high vehicle registration fees, high cost of food, etc. If they don’t like all the extra taxes and higher costs of living, they can move. They need to vote with their feet.

    A techie in San Francisco can easily get a job in the SLC or Provo area in Utah if they want to cut their cost of living down. Adobe, eBay, Novell, Oracle, and even the NSA are in northern Utah. I live down the street from my old college professor and a couple weeks ago he said he had a few companies contact him looking for programmers in those area. They are in desperate need of THOUSANDS of programmers. Starting pay is around $80k/year. According to BestPlaces, the cost of living in San Francisco is about 107% higher than Provo. The biggest part of that is housing at 289% higher.

    When I was looking at BestPlaces, they had some jobs in Provo and San Francisco posted on the side. A Senior Software Engineer at Oracle in SF is offering $101,039. A Senior Software Engineer at Novell in Provo is offering $92,981. That Oracle job is like getting a $48,895/year job in Provo. The Novell job is like getting a $192,141/year job in San Francisco.

    I don’t understand the appeal of big cities, but I know a lot of people are drawn to them — that’s why they are big cities! That CHOICE comes at a cost. As someone that got out of a big city (I grew up in San Diego), I have no interest in subsidizing people that make the same amount of money that I do just because they choose to live in an expensive area.

    • says

      Travis, do you live in Utah by chance? I ask because I work at an Internet company as a developer in Orem and agree with your cost comparisons with salary and cost of living here in Utah -vs- San Francisco. I’m a firm believer that right now if someone wants to create wealth, they should learn to be a programmer and go find a great job doing it. There’s so many openings and not nearly enough demand to fill it…

      • Travis says

        Jeremy, yes, I live in St George. I moved here to go to college when I was 17 and decided to stay since I like the area so much. Such a wonderful contrast to the San Diego area where I grew up.

        I graduated with my CIT degree from Dixie back in Dec ’02 (10 years ago next month!). Most people I knew in college moved up north to get jobs after graduating since they could take their pick of companies. Even at that time, our college professors were being contacted on a weekly basis by companies looking for programmers, sys admins, DBAs, etc. So long as you weren’t a goof-off, you got a good job and are easily making 6-figures by now. That demand has only increased since I graduated.

        I fully agree with your job assessment. Being in tech is like being an RN. There is such a high demand in so many places throughout the country, you can pick where you want to live.

  8. JayCeezy says

    Really compelling post, and replies. One point of information…California is a ‘tax donor state’, contributing more in Federal Income Tax revenue than it receives back from D.C. So is NY. So is TX and NV. Check this out, if you are interested in more detail: Federal Taxes Paid vs. Federal Spending received by State

    Utah, N. Dakota, S. Dakota, and all the other states we don’t want to live in receive far more Federal money from D.C. than paid. CA, TX, NV and NY are all subsidizing these states. The market determines where people want to live now (jobs, weather, culture, etc.) and changing the tax code will simply redistribute some money. And it will be mostly for the 10% of earners who pay 70% of Federal income taxes.

    My thought on the overall subject is the US will hit the fiscal cliff. The election is over, Obama is elected. Congress is not going to solve this. The fiscal cliff will solve it, ugly and painful as it may be. This pain is coming to the country, whether is is over 50 years, or 50 days. And the brutal truth is that it will not impact everyone the same way. So save your nickels, kids!:-)

    • Travis says

      Yes, a lot of people like to quote that 2005 information. The question is, are those numbers still accurate in 2012? Since 2005 we had a recession where California reached over 12% unemployment and they were the biggest recipients of the federal unemployment benefits extension (most 99ers in the nation). California is still sitting at 10.2% unemployment (49th in the nation). Do we have any up-to-date information that shows the flow of 2010 or 2011 federal tax dollars?

      According to a report in the LA Times, “Since at least 2005, more residents have left California than arrived here from other states.” (http://articles.latimes.com/2011/nov/27/local/la-me-california-move-20111127) How did that migration affect the federal tax dollars since the 2005 report?

      Keep in mind I am not arguing the 2005 data at all. I understand there are incredibly wealthy people that choose to live in California (think Hollywood types), so it doesn’t surprise me how much they pay in federal taxes. I am just curious to see what effect the Great Recession and the out-migration has had on the state and how it compares to the rest of the nation now.

      • JayCeezy says

        @Travis, the question is not if CA information is outdated, but does the comparison as a Donor state to Utah, N. Dakota, S. Dakota, etc. as Recipient states still hold? It does. You can sort out more recent information into 2009HERE, if you have the time, patience and inclination, and you will see that Utah is still a recipient state. If you do see that 2005 data “a lot” that is because it is the most recently compiled in this easy to read comparison chart. Quick points: Unemployment expenditures are a very small part of Federal transfers, certainly wouldn’t tip a state from donor-to-recipient. The people leaving CA are not, in general, taking the jobs with them. The people coming here are immigrants now, not from other states, as the article you linked confirmed. These newcomers are not coming close to paying their own share of Federal or State taxes, so further burden falls to the high-income earners. In CA, the top 1% of earners pay 49% of State income tax. Read that again. Wow, right?

        That said, I’m not sure more recent information is useful going forward, as the Federal deficit has exceeded $1 trillion for the past four years; the Feds are ‘donating’ far more (30%+) than ‘receiving’. QE1, 2, 3, various and sundry bailouts, the systemic overspending (including unemployment) are all funding a lifestyle that nobody in the US appears to have the will to sacrifice. There are very good reasons the problem hasn’t been solved; if it were easy and the will to do so existed, it would have been done. We shall see, in the fullness of time…

        • Travis says

          Thanks for the link, Jay. Interesting information. It shows a nice breakdown by state for “Total IRS Tax Collected” and “Total Spending.” For California, the 2009 total IRS tax collected shows $264.9 billion, which includes business income tax, individual income tax, and employment tax. The total federal spending for California shows $346.0 billion, which includes defense spending of $59.3 billion and non-defense spending of $286.6 billion.

          What am I missing? I know I’m missing something since that makes it look like California received $81.1 billion more in federal dollars than it sent in. Surely that’s not the case since California is a ‘tax donor state.’

          Yes, I actually wrote about California’s top 1% paying half of the state income taxes in my last post, then I deleted it since the post was getting a little lengthy. Crazy, isn’t it? But, when you consider California has 1/8 of the nation’s population and 1/3 of the nation’s welfare recipients, it’s obvious the state’s income earners are going to shoulder a massive burden. But hey, that’s nothing a little Prop 30 can’t fix, right?

          I still think it would be funny to watch Gov Brown’s reaction if half of CA’s 1% moved out of the state in the same year. Imagine what would happen if their state income tax revenue got cut by 25%. Knowing Brown, he would immediately start campaigning for a new Prop to raise taxes even more.

        • JayCeezy says

          @Travis, you are welcome and I’m sure you saw that Utah continues to be a recipient state for that period, as it has always been. What you are missing is the 2009 Stimulus ($64 billion went to CA) http://projects.propublica.org/recovery/ and the extreme Federal deficit spending since the meltdown noted in my last paragraph. This is money created by the Fed and purchased by the Treasury; no other state is giving CA money, as it is a combination of $1 trillion+ annual deficits, QE1,2&3, the $787 billion ‘stimulus’ in 2009, etc.

          The fiscal cliff would immediately give a revenue boost, cut spending, and allow the politicians to again avoid the hard choices. Of course it would result in (more?) recession, but those cuts will impact defense and Obama wants to cut it anyway. The elections are over, there is nothing in it for any politician to actively raise a specific tax or cut a specific line item. And the impact is not felt equally by all. I can’t figure out how the political climate would be any better than December 31, 2012 to kick this can down the road 3, 6 or 12 months. A bold call, I know. But, as I said previously, we shall see in the fullness of time.

    • says

      Great point you bring up JC. Given CA is a donor state, the rest of the country won’t mind bailing us out!

      You are too pessimistic on the Fiscal Cliff imo. I’m putting my money to work after this 6% broader market sell-off, and 20%+ sell-off from individual companies like Apple, etc.

  9. says

    I don’t think we will get to the fiscal cliff, even though there aren’t elections coming up, that could still be political suicide. That said, I think we need a permanent solution, meaning I realy hope that they just don’t kick the can down the road for another year. All that means is we’ll be reading the same post (no offense) in another year. Not that it’s not a great post, I just want to be in the business of looking toward the future and not be worried all the time because our politicians won’t do their job.

  10. says

    The problem with geographic tax adjustments is in the effort level to try to address it in the short time frame between when changes will be made and when they will go into effect. I am a software engineer by trade, the software impacts for the IRS, accountants software and products like Turbo Tax and Tax Act alone make last minute changes of that magnatude virtually impossible. I live in NY so I would be all for it, as $250k here is just middle class.

    The tax code is overly complicated and needs to be simplified to even out the tax burden and bring in more revenue. The government also needs to cut long term spending to balance the budget long term but until the economy is back on track the government needs to spend in places that have an immediate postive impact on jobs.

    The current and upcoming government is not actively doing anything to actually help the people they work for and there evidently is no way to truly hold them accountable.

    • says

      I had a meeting with the US Undersecretary of the Treasury during the Reagan years last year. He mentioned a study showing 15% was the ultimate federal income tax rate that brought in the MOST revenue due to a huge reduction in people’s desire to cheat on their taxes. Could make sense!

  11. says

    I am a very bad market timer! I keep on dollar cost averaging into the market. I won’t be dependent on my retirement savings in retirement so I can afford that strategy. As far as tax reform, I would love to see an incentive for savings. The only incentive are IRAs (including 401K, IRA & Roth IRA) which are either tax deferred or tax free. I would like to see more. Making the tax code geographically sensitive will probably never happen. When you earn more you have more choices to shelter your income. No one can support that without a lot of criticism. Look what was said about Romney paying only an effective tax rate of 14%.

  12. Nikki says

    I guess I’m crazy because, like Krantcents, I’m just maintaining my dividend based portfolio, looking for good buying opportunities, and saving as much as I can. I guess I’m not one of these investors who think Obama is going to make the world explode; especially considering how much spending and speculation has been going on, worldwide, for the past quarter of a century.

    I do think ALL tax loopholes should be closed. I don’t claim any kind of deductions (while also paying income tax) and I don’t like listening to people whine who find every way possible to avoid paying the passage of being a citizen in a first world country. I have no problem paying for schools, even though I am child free, and I have no issue paying into social security and other programs because that’s how you maintain civilization. I don’t know why so many people have these fantasies about returning to the good old days of Industrial Victoriana, because most of these people would be dead from TB, overwork, malnutrition or some sexy combination of all three.

    But I guess it’s easy to believe nightmares are dreamscapes when you’re living a relatively good life.

    Sorry about the rant. I think I need to just stop reading PF blogs for awhile. LOL!

  13. says

    I think land/housing is the smart investment right now, and DH and I are currently looking into that. Land always holds its’ value. Even if the dollar became worthless, land would still be worth something. We all need somewhere to live, regardless of the value of a dollar.

  14. Traineeinvestor says

    It’s a mess and it will remain a mess. My HK$0.02 worth is that we well see some tax increases, some sending cuts but they won’t be enought to deal with the issue so a big chunk of it will be kicked down the road. Oh yes, and benefit erosion through inflation and more tax increases by stealth as various fees, charges and levies are introduced.

    FWIW, the experience in some countries is that introducing a (higher) capital gains tax actually resulted in asset prices moving higher because people figured out that they were better off not selling.

    Lastly, since capital gains are at least partly the result of retained earnings which have already been taxed, taxing capital gains is another form of double taxation (just like dividends). Several countries recognise this and have tax systems which reflect the wrongness of taxing the same income twice.

  15. Mitch says

    Sam to your comment of
    “Hopefully nobody under the age of 50 is depending on Social Security in retirement because you are doing everything you can to save and build multiple income streams.”

    What percentage of the the working population below the age of 50 is not depending on Social Security in retirement in your opinion?

  16. says

    That structured note sounds like a nice investment. I like the time frame of 3.5 years and those are good terms. I typically buy CDs that are about 3-5 years in length. I haven’t been doing much trading lately though.

  17. says

    Though I am optimistic that we will not get to the point of fiscal cliff, I still believe that law makers should work on a new budget resolution quickly. I fear that crime rate will increase when federal unemployment benefits vanishes. I think I will be withdrawing some of my 401 and invest it on business and stocks or mutual funds instead.

    • JayCeezy says

      @Manette, many people do not know this, but there has been no Federal Budget for the past 3 years, and no spending resolutions even considered in the Senate. There have been no political consequences for those in office, the Budget Control Act has put Federal expenditures on autopilot.

      This is one of the reasons I have been enjoying Sam’s book and blog; he sees and says things the way they are, not the way the should be or he wants them to be. We can all only react now, have some dry powder if opportunity arises and protect assets at risk. Good luck to us all!:-)

  18. Roberto says

    How about all AMERICAN’S pay their fair share through a simplified flat tax system. Those who currently don’t pay federal taxes are protected by the same national defense, drive on the same roads, are supported by the same government infrastructure as those who do. In fact, those at the bottom of the scale utilize the majority of benefits handed out by the government.
    The bigger question is – Why should you be penalized in America for working hard, living within your means and making sound financial decisions? My wife and I have earned every dime we have and resent the implication that somehow we are the villains in this country. Anyone who thinks a family making $250,000 is rich obviously has never paid their own way WITHOUT government assistance.
    This past election was unfortunately a referendum on makers v. takers. Makers lost!

  19. Norman Harruff says

    Don’t make the tax code more complicated by adding locales for tax rates. It you want lower living expenses move to S. Dakota. Why is it that you don’t mention the ability to pay without effecting the acquisition of necessities when talking income tax rates? Also, it is refreshing that you vote according to what is best for the country and not for your own self interest since you appear to place yourself in the lower 50% bracket.

    • says

      Because nobody deserves to live in South Dakota. Life is too short. It’s not difficult to implement three income taxation categories. I think it would generate way more revenue to the IRS due to less tax avoidance.

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