The Congressional “Super Committee” established by last summer’s debt ceiling deal has less than a month remaining to propose a plan to reduce the nation’s deficit.  As hope for a “grand bargain” fades, the country is facing the prospect of severe cuts in defense spending, a possible government shutdown, continued high unemployment, and higher taxes.

               The Super Committee:  The deal reached last summer to raise the country’s debt ceiling and avoid a government default calls for the formation of a bipartisan Congressional committee to identify at least $1.2 trillion in additional deficit reduction, to be added to $900 billion in already agreed-upon spending cuts to take effect over ten years.  The Committee must produce a plan by mid-November and Congress must consider it in an up-or-down vote (no amendments or filibusters) before Christmas.

               If the committee fails to produce a plan -- or if Congress does not adopt the Committee’s plan -- then, under a process called “sequestration,” automatic spending cuts of $1.2 trillion are implemented over ten years.  Cuts to Social Security, Medicare, and Medicaid benefits are not permitted in sequestration.  The sequestration cuts must be split evenly between defense and non-defense programs.  When added to defense cuts already agreed-upon, total defense cuts would approach $1 trillion.

               Speaker Boehner has said the House Republicans on the Committee will not agree to tax increases as part of a plan.  That threat has led Democrats to reject entitlement (Social Security or Medicare) changes, asserting that they will not “balance the budget on the backs of seniors when affluent Americans are not paying their fair share.”  Even if the Committee manages to breach this divide and produce a “grand bargain” that reduces entitlements and increases taxes, that plan is unlikely to pass the House, where “tea party” Republicans have signed a pledge not to raise taxes under any circumstances.

               The standoff leaves the Committee attempting to save $1.2 trillion through spending cuts alone.  Whether the Committee agrees on a slate of cuts or cuts are made automatically through sequestration, the result is the same: a plan that reduces the deficit --currently standing at $1.3 trillion -- by only $210 billion a year, without addressing entitlements and taxes, the real drivers of future deficits.

               And even the spending cuts may not survive.  Some legislators -- notably Senator McCain -- have threatened to seek legislation in 2012 to unwind severe cuts in defense spending.  That legislation would essentially nullify last summer’s deficit cutting deal entirely.

               Additional deadlines also loom.  Congress still must pass a budget to run the government in 2012.  If Congress fails to adopt a budget (or to extend the deadline) by November 18, the federal government will shut down on that date.

               Jobs: As Washington has focused on deficit reduction, the economic recovery, already fragile, came to a halt and the unemployment rate rose.  This is not surprising.  Deficit reduction is anti-jobs, at least in the short and intermediate term.  Meaningful deficit reduction not only requires the government to eschew stimulus measures; it requires it to cut back on normal spending.  The agreement to raise the debt ceiling will result in over $2 trillion in spending cuts, almost half of which likely will come from defense, an industry that employs a large number of Americans.

               Faced with rising unemployment, the President has proposed a new plan to create jobs.  Much of his plan follows the contours of his 2009 stimulus package, calling for additional spending on infrastructure, state aid, and expanded unemployment benefits.  But over half of the cost would come from tax reductions, lowering the 2012 Social Security tax rate for both employers and employees to 3.1% (the 2011 rate for employees is 4.2% and the normal rate for both is 6.2%).

               The Senate Republicans, not surprisingly, have rejected the jobs package as unwarranted additional government spending.  The Senate Democrats are now in the process of resubmitting for a separate vote each element of the jobs package, to be funded by increased taxes on families with income over one million dollars.  The Republicans are dutifully rejecting each element as it comes up.

               There remains a small chance the Republicans might agree to the President’s call for temporary employment tax reductions for employees and businesses, provided that relief is not funded with additional taxes elsewhere.  A reduction in the employment tax rate would be in line with Republican promises to keep taxes low.  But it would not be consistent with Republican promises to reduce the budget deficit.  The Social Security tax reductions in 2012 will cost the government more than the entire 2012 cost savings to be achieved from the debt limit deal that consumed Washington this summer.  In other words, after all the rhetoric, drama, and focus, the deficit actually will be slated toincrease in 2012 if the President’s tax relief proposal is adopted.

               Regardless, it appears that the unemployment rate will remain high for an extended period.

               Taxes:  The President wants Congress to adopt a “balanced deal” for reducing the deficit, incorporating both spending cuts and tax increases.  As noted above, Republicans presumably will not agree to tax increases in the Special Committee, and the sequestration process does not impose them.  But the President has an alternative if Congress does not pass a tax increase.  The “Bush tax cuts” are slated to expire at the end of 2012, when he will still be in office regardless of the outcome of next fall’s election.

               This sets up a fascinating legislative dynamic for year-end 2012.  Given the parties’ competing views on taxes, Congress is unlikely to pass any tax legislation before the election.  Congress then will have to return for a three-week lame duck session between Thanksgiving and Christmas to address the expiration of the Bush tax cuts.  The Congress that returns is the existingCongress -- a Republican-led House and Democratic-led Senate, regardless of the election results.  At that point Obama either will have been re-elected -- and may feel newly-empowered to institute tax increases -- or will be a lame-duck president who can do what he believes is right without concern for the consequences.  Given the short time frame for action and the acrimonious post-election environment, it may be difficult for the parties to agree on an extension of some or all of the tax cuts.  If Congress fails to pass legislation and the Bush cuts expire, taxes increase across the board in 2013.

               Although tax increases are never welcome, there is a silver lining.  Expiration of the Bush tax cuts is calculated to raise $3.5 trillion, virtually eliminating budget deficit concerns.  A reduction in future deficits likely will prompt S&P to reinstate the country’s AAA rating and China to cease its sword-rattling over the United States’ fiscal condition.  The markets, too, likely will react favorably to the prospect of lower deficits.  Thus, while investors may face higher taxes, they also may find the values of their investment holdings enhanced substantially.

               Steps for investors:  For investors, ongoing high deficits likely mean protracted slower domestic growth, suggesting that continued investing in companies based overseas (or U.S. companies that sell products overseas) may make sense.  Global concern about the deficit could cause the dollar to weaken over time, suggesting that overseas debt denominated in local currencies, too, could be a good play.  Municipal bonds might make sense as well, as their value typically increases as tax rates rise.

               And, finally, the prospect of higher taxes in 2013 suggests that investors who are facing the prospect of recognizing gains -- such as by selling a business or diversifying a concentrated stock position -- should do so while tax rates remain low.  Investors also should consider setting up “dynasty trusts” to transfer assets to future generations, thereby taking advantage of the $5 million gift and estate tax exemption slated to expire at the end of 2012.

 

 

 

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