The term “Financial Cliff” is being bantered about quite a bit lately, but not all Americans really understand what it is, let alone the implications. The “Financial Cliff” refers to two separate developments that will take place unless Congress acts to avoid one or both of them.
One of the automatic changes that will occur, without action by Congress, is that the tax structure currently in place will expire at the end of this year, to be replaced by the old tax structure that existed in 2001. This means substantial increases in taxes for most Americans. At the same time, the payroll tax, which has been reduced for the past two years, is due to rise to its previous level. These tax changes mean less take home pay for every American worker. A reduction in net earnings will mean that consumers will have less to spend (and save) and economic growth will decline.
The other automatic cut that will occur at the end of the year is in Federal spending, with one half coming from the defense budget and the other half coming from mandates such as Social Security, Medicare, Medicaid and other basic services. This cut will also have a negative impact on the economy, as federal government spending that goes into the economy will be reduced.
To put this all in perspective: the growth we have been experiencing this year is roughly 3.1% with expectations that it will be similarly slow next year. If these two automatic changes go through, it is possible that the economy in six months could be negative 3%. Following the downturn in economic growth, the economy would be expected to begin increasing, and by 2014 to 2015 it could be growing better than today.
Will Congress act to change or eliminate these two automatic actions? At this point, no one really knows, but what if they don’t? In that case, we are likely to see unemployment increase again, housing values decrease and everyone will feel the pinch! It has also been suggested that if this is allowed to happen, long term benefits to the economy could be better than if Congress were to attempt to blunt the initial pain. The reason is that if we had a reduction in government spending and an increase in taxes the national debt would begin to fall. The financial strength of the United States would grow, and ultimately it would be favorable to business and consumers.
Part of this hinges on what I have been saying for most of this year: the United States has the highest productivity in the world, the best quality in the world, a stable government, and cheap energy in the form of natural gas. But our financial strength is being sapped by overspending and under-taxation. When you couple these with a strengthening financial situation, we cannot be beat! Many parts of the world are implementing austerity measures, while we in the U.S. have continued to have low taxes and high government spending. At some point and in some way, we too will have to feel the pain. So will Congress now let things go without intervention? Do politicians understand economics? Does any politician want to take away benefits and increase taxes?
One last comment. If the tax changes take place, the capital gains tax will rise to 25% and the taxes on dividends will go from 15% to a maximum of 42.5% (almost triple) and everyone will be paying more taxes on income. Are we a country that thinks long term (take your pain now) or short term (send the pain to another generation)? The “Wealthiest 1%” are not going to get us out of our mess. We all have to participate to make it happen!