Everybody 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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About the Author: Sam began investing his own money ever since he opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $150,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2018 and beyond.