Facing the Fiscal Cliff Solves 77% of the Deficit Problem in One Move

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With the election over, Wall Street is now obsessing over the possibility that the "fiscal cliff" negotiations may end in stalemate.

Well I have news for them: a stalemate would be good for the U.S. economy, and any deal that does not preserve most of the fiscal cliff is not worth having.

Here's why.

By ending Social Security tax relief, the Bush tax cuts and cutting spending on both defense and domestic programs, the "fiscal cliff" cuts a deficit projected by the Congressional Budget Office (CBO) at $10 trillion over the next 10 years down to $2.3 trillion.

Contrary to all of the media caterwauling, that's not a dreadful fate.

In fact, it is exactly what we ought to be doing, since it solves 77% of the deficit problem in one fell swoop.

Of course, lovers of low taxes (which includes me) will claim that we should not support the "fiscal cliff" because it will raise taxes on everybody. But honestly, what's the alternative?

The reality is that President Barack Obama won the election and that he passionately wants to raise taxes on the rich. It's more important to him than any other outcome from this negotiation.

In setting out his objectives he twice reiterated that he was non-negotiable on tax hikes for the rich, and wanted to close the budget gap primarily by tax increases.

And guess what: Tax increases in budget negotiations are much more real than spending cuts, because once the legislation is written, they always happen, whereas politicians often find a way to weasel out of a spending cut deal once the klieg lights are off.

Thus, given the Republicans' weak negotiating position, it's likely we'll end up with the tax increases on the rich anyway.

However, tax increases alone will do little to reduce the deficit.

That will leave the deficit as a real problem, and may well produce yet more tax increases on the rich as a precondition to solving it. To increase taxes on the rich, even modestly, without solving the deficit problem seems a very bad idea indeed.

A Fiscal Cliff Reality Check

The worst outcome of the negotiations would be four more years of trillion dollar deficits.

That would push the federal debt to around 150% of GDP, making it a gigantic problem for the next president in 2017.

In addition, when combined with Fed chairman Ben Bernanke's easy money policies, it would drain away the U.S. capital base still further, as the country runs huge balances of payments deficits and sells huge amounts of Treasury securities to foreigners.

By 2017, the U.S. would be a much poorer country, with high unemployment and a huge recession to come, probably accompanied by a financial crisis.

Obama, out of office in January 2017, may not care about this, but the rest of us should.

If tax increases are required, it's better to impose them on everybody. U.S. voters have effectively been running up the national credit card bill in the last four years, even while trimming their own credit card balances. Middle-income voters must be taught that they cannot simply vote to expand government ad infinitum and not pay for it.

By enduring the fiscal cliff tax increases, the public will finance its spending wishes on a pay-as-you-go basis (or closer to it), keeping the country's debt position under control.

The tax increases will also lessen consumption, thereby reducing the balance of payments deficit and our dependence on foreigners.

The Republicans in Congress cannot get tax cuts, but they do have the ability to stop massive new spending programs. If they hadn't that ability, I would not favor the fiscal cliff; there's no point raising more money through taxes if the feckless administration is only going to spend it on new rubbish.

But with spending controlled, the extra money raised will go to improving America's fiscal and debt positions, as it should.

The Fiscal Cliff Comes With Pain

Admittedly, the fiscal cliff does include some painful changes.

The rate of estate taxes goes back up to 55% as the limit falls to $1 million. Dividends will also become fully double-taxed again. But those things can be changed in a later negotiation, when the Republicans can put limits on tax deductions for housing, health insurance, charities and state and local taxes, all of which (if only limited, not eliminated) affect mainly upper-income voters.

Making dividends tax deductible for corporations (and keeping full tax for investors) would be the ideal corporate tax reform, because it would eliminate most corporate tax loopholes and force management to pay most earnings out to shareholders. But this negotiation could be done in a revenue-neutral way, since the deficit problem would be more or less solved.

Of course, people worry that the fiscal cliff would cause a recession, but why is that a problem?

We're bound to have another recession before 2017 anyway, so the Democrats should want to get it over with.

For Republicans, a mild fiscal cliff recession, without an accompanying financial crisis, is a price well worth paying to solve the deficit problem. It will also provide a "learning experience" for the electorate on how government overspending damages the economy.

The slogan for 2013 is simple: No more free lunches!

You just can't kick the can forever. Now is the time to deal with the fiscal cliff.

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About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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