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What Happens if There's No 'Cliff' Compromise?

Jason Stipp
Robert Johnson, CFA

Jason Stipp: I'm Jason Stipp for Morningstar.

As the budget wrangling continues in Washington, it looks increasingly likely that we won't get a deal for the fiscal cliff prior to Jan. 1. So what happens if we hit that deadline? The results might not be as dramatic as you think.

Here to offer his insights is Morningstar's Bob Johnson, our director of economic analysis. Thanks for being here, Bob.

Bob Johnson: Great to be here.

Stipp: We've talked about a lot of these things in different pieces before, in our talks, but I wanted to break down--since it looks like we might go over the cliff, so to speak--what exactly will happen on Jan. 1, and what would happen over time, and maybe what's not likely to happen at all?

The countdown clocks that we see on some websites, there's lot of concern about this hard deadline that we're seeing, but it's not really a cliff. There are some things that will happen quickly and sooner and some things will happen later.

Let's talk about, if we don't get a deal, we hit Jan. 1, what are we likely to see as far as cutbacks and increased taxes?

Johnson: I think the very first thing will probably be raising the Social Security tax back up to 6% again from 4%. We cut it in 2010 by 2% as a stimulus measure for the economy. Obviously, with Social Security having issues, there is widespread support that, well, maybe this isn't necessarily the best way to stimulate the economy, so let's leave that off the table.

So, there seems to be pretty broad agreement that will happen, and that's the law of the land right now. It's not like a withholding [change] that you can play loosey-goosey with; it's supposed to be so much out of each paycheck, and some people are going to get paid next Friday, and those people who get paid then will probably see the increased rate of the Social Security tax.

Stipp: So that amount will be $110 billion that won't be in your pocket because of this increase back to the normal rate of withholding for Social Security?

Johnson: Right, $110 billion out of $720 billion altogether

Stipp: Which is the total "cliff" when you add it all up.

Johnson: Yes.

Stipp: The second one is the unemployment insurance. There was an extension, and that extension is going to be going away. What effect will that have, and that's likely to kick in right at the beginning of the year?

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Johnson: And that's not massive, but it is $35 billion of the $700 and some billion. So, it's not a huge deal--about 5%--but it is an important deal in some states. I noticed on Connecticut's website today, it's saying, keep filing and maybe if the money comes through, we can send you more money. Don't stop filing. But right now, there's no money for anything beyond 26 weeks, which was a huge change from the 99 [weeks of prior coverage]. Some people think we are just rolling back to the last [extension], but it's rolling us all the way back to the 26 weeks [of unemployment insurance coverage].

Stipp: And it seems like that's pretty likely to happen. Even if we do get a deal, it sounds like there will be some cuts there on how much unemployment you get.

The last one that you also say is the law the land is some increased revenue for the government from Obamacare. Can you explain what that is?

Johnson: Some of the investment income and the amount that's subject to tax for Medicare will go up. And that's not a huge number, but it will happen right away. The investment income part of it will be paid with your taxes next year. But it's still maybe a $25 billion number. So it's not insignificant. And that will happen.

Stipp: So we have that, we have the unemployment insurance that's going to be cut down, and we have the 2% payroll tax cut that's going to expire on the Social Security withholding, so that amounts to about $170 billion that's likely to happen; you're going to start seeing the effects of those beginning in January.

There are some other things that are part of the fiscal cliff that, if we don't get a deal right away, would likely happen over time. So this is assuming that they still continue the wrangling into next year and we don't get a deal--hopefully we'll get one--but we don't deal in the first few weeks. But those won't hit on Jan. 1 even if we do go over this cliff.

There are few big ones in here. Let's lay them out. One of them is the AMT patch that they've had to do every year and they are still wrangling over. What does that amount to, and how would that kick into effect?

Johnson: It's a really big number. It's called the alternative minimum tax, and it's a way of making sure people pay enough taxes, and [the government] set an exemption amount, and when they set that exemption amount, they were meant to capture something that was probably in existence 20 years ago in terms of cost of living. And every year, they boosted that up--at the last minute, always--with the rate of inflation, so the exemption moved from $40,000 to the $70,000-$80,000 range [over time].

And now, unless they do something, that exemption is going to go back to $40,000, and it's going to go back not just for 2013, but for 2012, which is already over. But you won't feel that until you actually have to mail in the check [to the IRS], and I think that this is such an onerous tax--it would go from [affecting] maybe 6-9 million people to 40 million people--that it would be political suicide to let this happen. So I don't think it's going to happen, and it's not money that we'll likely see go out immediately.

Stipp: So really, for most folks, it would behoove them not to pay their taxes [immediately] given that there's this uncertainty. You think they are going to clear it up; hopefully they will. Technically speaking, the inflation adjustments will expire at the end of the year, but it's not like that's money that's going to come out of your pocket right away on Jan. 1.

Johnson: Exactly.

Stipp: The other [part of the cliff] are Bush tax cuts that will be expiring, and there is a variety of different tax cuts. Some of them will involve the paycheck that you get every week and some of them are more investment related. Can you talk about how you see those kicking in if we don't get a deal?

Johnson: The whole Bush tax cut is $210 billion, so it's kind of a big number. Some of it relates to the 10% rate, two worker families and deductions you get there, some of it relates to investment income which will tend to get pushed off over time. But [for the items that would] hit low-end people on their payroll tax, my guess is that they will keep the payroll tax withholding amounts the same as they were last year. They won't goose it up for the new effects of the law expiring. The Congress sets what they want to collect in taxes and then the IRS sets a withholding so they match. And I'm sure the IRS doesn't want to sit there and collect a whole bunch of money and then not collect the money [depending on the resolution to the fiscal cliff]; it's going to wreak havoc on the numbers. So, I really don't think that they'll change the withholding tables at least until the end of January, maybe even February.

Stipp: So while these negotiations are going on, they're not going to immediately kick in, you think, because they're going to wait to see what is the result of the negotiations, who is going to have to pay a little bit more, who won't get hit as much. And so you won't see that kick in immediately on Jan. 1.

The last one is all of the spending cuts that we're expected to see as part of the fiscal cliff, and although they are supposed to have a deal by Jan. 1, if they don't, it's not like this spending is going to … completely stop right on the dot at midnight.

Johnson: You're talking about the so-called sequestration, which is basically cut half an amount from a total for defense and half from social programs, for a total of about $110 billion, again on an annualized basis. And those won't probably happen until you get closer to the end of the fiscal year, which is September. They'll have money at the beginning of the year. It's only when you get to the end of the year when you don't have money in your buckets anymore and then, oops, I guess we've got to stop right now. So, that won't hit right away.

Stipp: So, it sounds like if we don't get a deal--certainly we'd like to see one--but if we don't get one, it's not exactly a cliff on Jan. 1. It is a steep slope, and if we didn't get a deal, we would see a lot of headwinds on the economy, but important to keep in mind that the Jan. 1 date isn't necessarily a wall of spending cuts and tax hikes.

Johnson: Exactly. And probably the most worrisome thing about what happens in January, or the first two weeks of January, is unfortunately, it appears like, except maybe the Obamacare tax, that it's going to hit low-income earners the most. Obviously they're important in determining spending.

Stipp: Okay, Bob. Well, thanks for helping us keep on top of all the fiscal cliff issues and for joining me today.

Johnson: Thank you.

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