Home>Video>A Sanity Check for Fiscal Cliff Watchers

A Sanity Check for Fiscal Cliff Watchers

Fri, 30 Nov 2012

We outline some big takeaways, likely outcomes, improbable outliers, and prudent strategies for investors anxiously following the fiscal cliff drama.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar. As the fiscal cliff drama continues to unfold with alternating optimism and pessimism in the headlines, we're hoping to bring some sense and sanity to the news for investors. Joining me today is Morningstar market's editor, Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: Jason, happy to be here.

Stipp: So we got some important news this week on this on this ongoing so-called fiscal cliff drama. Can you just break down the major points that we learned from the last few days?

Glaser: It really has been a drama. Certainly, both sides are trying to kind of play up as much as possible, kind of the importance of this and play up to their basis. And I think we certainly saw that this week. The president came out with the first kind of concrete proposal, offering that he wanted to raise revenue about by $1.6 trillion to restore or to keep the payroll tax cut; extend unemployment benefits; have some infrastructure spending programs; really not worry about too much of entitlement reform right now; and also get rid of Congress' ability to raise the debt ceiling and give that power to the administration.

I think this definitely represents the high watermark of exactly what the administration wants. I don't think they think that this is something the Republicans would accept. The Republicans have already said and rejected this proposal outright. I think it's really just the kind of opening part of this negotiation, and it's going to take a while before we kind of get to the outline of a deal that we think we already know.

The Republicans have said that they are willing to accept about half that much in new revenue, about $800 million. Certainly there's lot of discussion about if that's going to come from higher rates, if it's going to come from lower deductions. They don’t know exactly the best way to get it, but they do seem open to raising that revenue, which is something that was not the case a few years ago when we were having these discussions before.

There's also a sense from the Democrats that they are willing to make maybe deeper cuts to entitlements than they would like ideally and are willing to make some spending cuts to kind of bring the two sides closer together. So certainly, I think there's still room for agreement. I think that just because this first offer was kind of rejected out of hand, it doesn't mean that subsequent offers won't get closer to something they can come together on, but it's not going to happen without a lot of drama.

Neither side wants to be seen as totally giving in. President Obama took a lot of flak for extending all the tax cuts before instead of letting all of them expire, or only letting them expire for high earners. The Republicans don't want to be seen from their base of having agreed to raising taxes or having agreed to unpopular measures. So I think we're going to hear just a lot of noise. But certainly, they still seem to be moving down this path toward that basic outlay of agreement that we saw coming together in the last few weeks.

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Stipp: This back-and-forth of negotiation is part of being able to save face later. But you actually do see that there is some consensus on some primary parts of this deal that may come together ultimately?

Glaser: I think so. It seems extremely likely that we're going to get a two-part deal. That in the first part, we're going to take care of some of the things that are really very pressing. So things like raising the debt ceiling. If we don't do that, we're going to run into the same problems we had [in the summer of 2011], which I don't think is anything that anyone wants to relive.

I think there are some other things like making sure that alternative minimum tax doesn't hit a lot more families this year that both sides want to do. I think generally speaking, the chance the payroll tax cut continuing to be extended or unemployment benefits being extended as well seems extremely unlikely. This Medicare doc fix, the idea of sharply cutting Medicare reimbursement rates, is probably unlikely to happen. It's the same thing with taking the estate tax back to where it was prior to the Bush-era tax cuts; that probably isn't going to happen.

So I think we could see the first part of the deal really built on that general consensus of "Hey, we're going to raise some revenue, but we're going to really not keep all these things from totally falling off of the cliff, so to speak." Defense spending will probably be in there, as well.

Then in the second part of the deal, after you kind of take care of the things that really are short-term concerns, then they'll kind of tackle some of those long-term entitlement issues. So how do we make sure that Medicare can stay solvent for the long term? Do we need to make changes to Social Security? Do we need to make changes to the retirement age? Where else can they find spending cuts?

I think that's definitely the trickier part of this whole deal, and I think it's an area that we're going to be talking about for years, not just months. But I think certainly seeing kind of that two-step process is the most likely given that we just don't have that much time before Jan. 1 to deal with some of those underlying issues.

Stipp: Hopefully once we get a shorter-term agreement, that would be the good news. But maybe the bad news for investors is that this is going to extend for quite a long time, since it's just the very beginning of some very important and protracted talks on these issues. Lastly, though, Jeremy, for this week, for investors who are looking at this back-and-forth [debate], even if they understand the basic framework and can get a sense of where we might end up, what should they be thinking right now? What kinds of actions should they or shouldn't they be taking given this ongoing debate?

Glaser: This is definitely the most challenging part because everyone's tax situation is so different. It's not as simple as saying, this one thing is great for everyone or this one thing is terrible for everything. So, certainly we encourage everyone to talk to their tax advisor and figure out what their situation is going to look like next year as well as what their situation is going to look like in the future, before making any big moves. But certainly big moves might not necessarily make sense right now.

I think that we hear a lot of some radical discussions right now here and there, such as getting rid of 401(k)s, or getting rid of the mortgage interest deduction. I think those kind of proposals are very unlikely to happen.

We have a bit of a path-dependency problem with taxes, where certainly, if we were building a tax code from some absolute scratch, would we come up with what we have now? Absolutely not. There are probably different ways to do it that would be more efficient and that would work better. But the problem is we have to deal with the tax code we have now, and getting from where we are now to something better is not that easy. We can say we should get rid of the mortgage deduction, but that would have a hugely negative effect on home prices, which is something that I don't think anybody wants right now. It would have a big impact on how much people want to borrow for those houses.

So that's problematic. Changing the way that 401(k)s work all of a sudden is not something that's probably going to happen overnight when there's other levers that we can pull that might be a little bit easier. I think that trying to maybe get ahead of some of this radical proposals, you could end up doing more harm than good by getting away from your long-term plan in speculating that some of these are going to happen. I think that's extremely challenging.

I think another important point is that, tax efficiency is just going to become that much more important, kind of no matter what happens. With a stagnating population growth, with rising health-care costs, these entitlement issues, these tax issues are not going to go away. Like I said, we're going to be talking about it for years and decades. I think the idea of focusing on Roth IRAs, maybe recategorizing your IRA into a Roth IRA at lower rates might make sense for some people thinking about tax-free income from municipal bonds. Those kind of tax-efficient moves are going to make just even more sense if rates go up, which looks like in some ways that they will. So those kind of things that made sense before will continue to make sense.

I think another important point, especially for high earners who are going to be hit by this new 3.8% Medicare surcharge on investment income, will probably need to look more closely at moves that they might want to make in 2012. That [surcharge is] almost certainly going to happen given that the Supreme Court has now upheld Obamacare and that Obama has been re-elected. That's definitely going to be there. So for people who will have a lot of income and a lot of it comes from investments, they might want to think about whether it does make sense selling a piece of property or selling something that has appreciated significantly to get that lower rate now.

Again everyone's situation is going to be different. There are probably small things that people could do on the margin, maybe pulling some stuff forward from 2013 to 2012. But given that it looks like this deal is not going to result in radical changes to the tax code, making big moves, really putting tax efficiency in front of investment returns, putting it in front of having a solid long-term allocation, having a solid long-term plan, probably doesn't make a lot of sense and could end up hurting your aftertax returns over time.

Stipp: Jeremy, we will be checking in with you and several other Morningstar experts as this debate unfolds in the coming weeks. Thanks for offering the clarity, today.

Glaser: I appreciate it, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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