Don't Get Stung by President Obama's Deficit-Reduction Plans

In the last 10 days, U.S. President Barack Obama has unveiled three distinct deficit-reduction plans to solve the nation's economic problems.

While all three have their good points, each has its own set of problems, too - including the time-consuming political firestorm we can expect to see as the plans are debated in Congress.

We can make some educated guesses about how this will all play out - and how the final plans will help or hurt the American economy. But the bottom line is that you as an investor can't wait to see how the deficit-reduction saga ends: You need to take action now.

So let's take a look at the proposals, the likely outcomes - and the moves you need to make immediately.

A Trio of Deficit-Reduction Plans

President Obama has unveiled three overhaul plans for the U.S. economy - a "jobs" plan, an "offset" plan and a "deficit-reduction" plan.

Of the three, the "offset plan" that calls for reductions in tax deductions is clearly the best. But there are some good ideas in the other deficit-reduction plans, too - not to mention a couple of real stinkers.

Here's a look at each of the three plans - the good, the bad ... and the downright ugly.

The "Jobs" Plan: President Obama's jobs plan is a mix of spending on infrastructure and providing aid to state and local governments, both of which were tried in 2009 and didn't work.

Government infrastructure spending is appallingly expensive in the United States - in fact, it costs more than twice as much here as anywhere else - because of the additional restrictions on its design and labor usage.

However, the Obama jobs plan also included a 3% reduction in employees' Social Security contributions (expanding and extending the current one-year reduction of 2%). Finally, it included a 3% reduction in employers' Social Security contributions, but only for wage bills up to $5 million.

For me, it's the last provision that made most sense and should be extended. Reducing employers' Social Security contributions by 3% reduces the cost of labor - which should expand the demand for it.

Look at it this way: If the "price elasticity" of labor is 50% (estimates for this piece of economic jargon are all over the place, but 50% is about the midpoint), then a full 3% reduction in labor costs should increase demand for labor by 1.5%, or about 2.2 million jobs.

That would reduce the unemployment rate by about 1.2%, taking it from 9.1% to 7.9%. To me, that's well worth doing.

Naturally, the Social Security trust fund can't afford to do this every year, but it should certainly be done for two years, because employer-hiring decisions take time to implement (and because U.S. unemployment still will be higher than we'd like in 2013).

But that's not all. There should be no "Mickey Mouse" restrictions to $5 million payrolls - it's just as important to encourage hiring at McDonald's (NYSE: MCD) or Wal-Mart (NYSE: WMT) as it is to promote hiring at the local corner store.

The cost of this would be about $300 billion, and would be evenly split between 2012 and 2013.

This alone is such a good idea that you could probably abandon the rest of the so-called "stimulus."

The "Offset" Plan: Speaking of stimulus, I have to say that President Obama's "offset" proposal is more attractive than his "stimulus" plan.

Since the gigantic U.S. federal deficit has to be closed, and it's probably impossible to close it entirely via spending cuts (though the closer, the better), then some taxes will have to go up. Of all possible tax increases, the most attractive (or least unattractive) are the Obama administration proposals to limit income-tax deductions to a 28% tax rate for those with incomes above $250,000.

Let's be clear here - tax deductions are big money. If you cut them all out, you could raise $9 trillion over 10 years.

That's enough to close the $8.5 trillion budget gap (based on the latest Congressional Budget Office (CBO) calculations, with "realistic" policy assumptions) - and still have a bit to spare.

You wouldn't want to do that - for two reasons:

  • It would make it too easy for the politicians to waste more money.
  • And some - but not many - of these deductions are quite valuable, and perhaps even critical. For instance, the IRA/401(k)/Keogh Plan exemption of pension-fund interest encourages saving. That's very necessary in the low-savings-rate-afflicted U.S. economy - and helps Americans pay for their retirement.

However, trimming down many of those deductions - even more than President Obama proposes - would be positively beneficial for the American economy. Perhaps we should even make them deductible for everyone - but only up to a 20% tax rate.

There's also the home-mortgage deduction - a proposal that always ignites emotional debates. Limiting the home-mortgage deduction would divert investment away from wasteful "McMansions," and into productive industry through stocks and bonds.

Limiting the charitable tax deduction would put an end to all kinds of scams, and prevent middle-income people from being forced to subsidize Wall Street's $100-a-plate, charity-dinner socializing and Warren Buffett's $31 billion gift to the Bill and Melinda Gates Foundation.

Reducing the municipal-bond-interest deduction is almost pure gain; it would again push savers into dividend-bearing stock-market investments.

When you get down to it, President Obama's "offset" is probably the only tax increase we should support; all other "deficit-fixing" efforts should be focused on spending reductions.

The "Deficit-Reduction" Plan: President Obama's "deficit-reduction" proposal is a total joke - there's just no other way to describe it.

This "plan" includes "spending cuts" that emanate from a wind-down in Iraq and Afghanistan that everyone has already calculated will happen anyway. It double-counts the tax increases we are already going to get. And it includes a "Buffett Rule" that, if implemented, would add yet a third tax calculation to the regular and Alternative Minimum Tax (AMT) calculations.

The alternative cost reductions in Medicare are phony, and his backstop involves an even stronger role for Obamacare's Independent Payment Advisory Board, which critics already say bears an increasing resemblance to the controversial "death panels" concept that was the topic of such incendiary debate back in 2009.

You know the president's plan has problems when the lifelong Democrat Maya MacGuineas, head of the Committee for a Responsible Federal Budget (CRFB), denounces it as "replacing one gimmick with another."

This proposal is said to help President Obama with his Democrat base, but it did nothing for me.

Three Deficit-Reduction-Debacle Investment Plays

The three deficit-reduction plans have their points. In fact, two decent ideas (and a third small one in zapping the hedge fund "carried-interest" provisions) is not bad going for a politician.

The real problem, however, is that not much of this is going to get adopted.

That leaves you with a couple options - and a small handicapping exercise.

On that latter point, if you believe that the employer Social-Security-contribution reduction will become reality, you should probably be in Wal-Mart Stores Inc. (NYSE: WMT) and McDonald's Corp. (NYSE: MCD), in order to take advantage of their labor-cost reductions.

But if you believe, as I do, that not much will change after the dust settles on the deficit-reduction-plan debates, the bottom line is that the credit problems of the U.S. government are not going to go away.

As investors, therefore, it's time to protect ourselves. We should probably have a position in the ProShares UltraShort Lehman 20+year Bond Index (NYSE: TBT), which takes a double-sized short position in long-dated Treasury bond futures. That way, when the T-bond market finally collapses under the strain, we will likely profit nicely.

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