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Economic News & Analysis—December 21, 2012

Fiscal cliff or fiscal staircase?

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

In the latest twist in the fiscal cliff negotiations, Republican leaders in the House of Representatives decided to forego a vote on House Speaker Boehner’s “Plan B.” As with most legislation, Boehner’s plan had numerous provisions, but the meat of it was to extend the income tax provisions of the last few years for individuals making less than $1 million per year. Apparently, the speaker couldn’t convince enough Republicans to vote for a tax increase on anyone. So now what?

Any deal that does emerge will have to be bipartisan. A proposal that raises anyone’s tax rates will most likely be voted down by Republicans. In order to pass the House, a compromise between Democrats and Republicans will need to be struck. While most members of both parties will dislike the result, it will be preferential to the alternative of having everyone’s tax rates rise.

In actuality, the easiest path would be to take a step back and pass a bill like the one the Senate passed back in July, which extended all the tax provisions for those making less than $250,000 per year. That would dampen the effects of the full fiscal cliff, perhaps dragging down 2013 gross domestic product (GDP) by 1.5%. This would occur in part because of the expiration of the payroll tax cut and partially because of the business incentives for corporations that file individual tax returns instead of filing as entities.

If no progress is made before the end of the year, the sequester—the spending cuts that arose out of the debt ceiling negotiations in August 2011—will likely go into effect, but perhaps only on paper. Those spending cuts can be delayed since they are phased in over the course of the year and can perhaps be reversed before the cuts begin to bite. Given the likelihood of a debt-ceiling debate in late February or March, Republicans may be hoping to use that as a bargaining chip to engage Democrats in discussion about entitlement reform or tax reform and to avoid the sequester.

The most likely scenario is that this entire fiscal cliff debate gets carried on through next calendar year since the small bill that is most likely to pass the House and Senate will only provide a one-year extension of tax provisions. At the end of 2013, we’ll probably be facing another fiscal cliff, but it will likely be smaller than the 2012 fiscal cliff. The fiscal cliff is becoming more like a fiscal staircase, where each year it gets pushed forward another year and shrinks in size.

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