Ask Stacy: Are We Heading Toward a Fiscal Cliff?

Without congressional action, a combined $600 billion of spending cuts and tax hikes will happen in early 2013. Sadly, members of Congress have already supplied ample evidence they can’t cooperate on anything, including major issues. So if the spending cuts and tax hikes take effect on schedule, the result will be an economy tumbling off what’s become known as the fiscal cliff.

This reader is justifiably afraid of the specter of government revenues collapsing while taxes rise – a combination that would most likely push our country back into a recession…

Hi Stacy:

What are your plans for the coming “financial cliff” the U.S. government is headed towards? Plan on holding onto U.S. stocks? Buying foreign moneys? Gold or silver?

I am probably not the only one worried about this, and an experienced money guy like yourself can provide some much needed advice BEFORE we get to this “cliff.”

What do you THINK? I will not hold you responsible for telling me what you think nor will I consider it financial advice, just so your lawyers will be able to sleep and let you answer the question.

– Steve

Here’s your answer, Steve…

First, while I do have a lawyer or two, this is America – I have the right to express an opinion. Before I offer it, however, let’s take a closer look at the potential problem.

The fiscal cliff: tax hikes

The end of 2012 will mark the end of a cornucopia of temporary tax cuts, some enacted during the Bush years, others by the current administration. Unless Congress acts to extend them, the following tax breaks will automatically expire:

• The 2 percent payroll tax holiday
• The enhanced dependent care, child and adoption credits
• The enhanced earned-income credit
• The repeal of personal exemption phase-out
• The repeal of limits on itemized deductions
• The enhanced student loan interest deduction
• The exemption for mortgage debt forgiveness

Many of these breaks were enacted with the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. The original laws were set to expire on Dec. 31, 2010, but were extended until the end of this year by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 and the Middle Class Tax Relief and Job Creation Act of 2012.

Although the automatic expiration of all these tax cuts will serve only to return us to the tax rates of the Clinton years, their magnitude, especially in light of today’s anemic economy, has been dubbed “Taxmageddon.”

What will it do? According to this Wikipedia page…

Based on figures from the CBO and Joint Committee on Taxation, federal taxes would increase by a total of $423 billion in 2013, if the tax cuts are allowed to expire. The non-partisan Tax Policy Center has estimated that for 83% of households in the U.S. there would be an average tax increase of $3,701 and The Heritage Foundation stated that those impacted by the tax cut expiry are primarily in the middle- and low-income groups, with its research finding that families would experience an average tax increase of $4,138.

While higher taxes will prove valuable in tackling the deficit, it will cost the economy – and potentially jobs – because Americans will have less to spend.

The fiscal cliff: spending cuts

Also good for reducing deficits but bad for the economy would be less government spending – something else potentially imminent.

The Budget Control Act of 2011 was enacted to create a compromise when Congress couldn’t agree on raising the debt ceiling. It requires automatic cuts in both defense and non-defense spending to begin in early 2013. While Social Security and Medicare were specifically excluded from the chopping block, nearly every other form of government spending could be subject to cuts that will total $110 billion per year: $55 billion to defense, and $55 billion to non-defense spending.

Spending cuts, like tax increases, will go a long way toward addressing our nation’s trillion-dollar deficits. But as with the impending tax hikes, automatically slashing government spending would be a shock to an already weak economy. It could also reduce defense preparedness and cut programs critical to helping those in need.

What’s going to happen?

Nobody knows. The options are…

1. Washington doesn’t act and both spending cuts and tax hikes come to pass.
2. Washington reaches a compromise that reduces the severity of both.
3. Washington kicks the can down the road by extending the deadlines.

While few politicians want to send the economy into a recession, if past is prologue, compromise will be tough to reach. The president and his party will probably try to preserve tax breaks for middle- and low-income Americans, while pushing for tax increases for those with high incomes. Republicans will probably favor not increasing taxes on our nation’s high-income “job creators.”

Nothing is likely to be accomplished prior to the presidential election, leaving precious little time to do anything before the end of the year.

What’s an investor to do?

Now let’s get back to Steve’s question: How we can protect our savings from going off a cliff along with the economy? He asks, “Plan on holding onto U.S. stocks? Buying foreign moneys? Gold or silver?”

My answer: Yes.

If you look at my personal portfolio, you’ll see that I have money in stocks and also in a proxy for gold, SPDR Gold Shares. While I don’t have money in foreign currencies, I’ve invested in companies dependent on international sales. I probably won’t change that mix as we head into these dangerous waters.

There are three reasons I’ll likely leave my positions unchanged.

The first is that I think the problem will be addressed, albeit only temporarily, by Congress extending the deadlines.

The second reason I’ll leave my portfolio intact is that I can’t predict the future. While what’s ahead looks scary, if our nation manages to avoid the fiscal cliff, the market could rally – and I don’t want to be on the sidelines if that happens.

The final reason I’m staying the course is the most important: The money I have in the market isn’t all the money I have. I’m diversified – some in stocks, some in cash savings, and some in real estate. That makes it easier to ride out storms like this one.

Don’t think my attitude toward staying invested means I’m complacent, or that the amount I have in the market is immaterial to me. I think this potential self-inflicted fiscal wound is deadly serious, and the money I have in stocks is critical to my financial future. But this is the way I manage money – I take what I consider appropriate risk, diversify, then hang on for the long-term.

If that’s not you, Steve – if you’ll need the money you have in stocks within a year or two, or stocks are too risky – I’d recommend you be wary and keep your savings somewhere safer. You’re right to worry.

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