Your Friendly Neighborhood Econ Nerd Statistician Helps Explain the “Fiscal Cliff”

Good Morning Everyone!

So, what has become a consistent theme for me, continues.  I do my best, as a lover of economics and a professional survey statistician, to explain matters of economic policy or situational economics that have notional implications.  I do this because I find a disturbing lack of context and history, primed with too much bravado and estimation-as-fact in national discussions on these matters.  Often times I start these conversations on FB to help my friends become more knowledgeable about topics that will potentially affect them, those discussions then get instantly transcribed to my blog for public distribution (after being scrubbed for personal information).  As always, I open myself up for discussion and debate, as I myself find that I am just of one mind, and one mind often does not encapsulate the entirety of a situation.  However, I will not tolerate, nor will I ever, bias or childish rant.  That filth deserves no place in educated discussion.  Freedom of speech will irrevocably be always tied to freedom of opinion, however selfish that opinion may be.  That being stated, here is my most current ongoing discussion on the “Fiscal Cliff,” updated as it goes on.  A cliff that holds a special place in my heart based on its audacity, and its ability to subsequently put me out of work…

Hello! Friendly neighborhood econ nerd and statistician here. If you have questions on what this whole fiscal cliff thing is, or why it may cause me to end up eating out of a dumpster, direct them here! 🙂

Does the so called cliff represent spending cuts and tax rises we need, and the whole ordeal provides both parties with plausible deniability?

Well, deniability maybe, but it certainly isn’t plausible. That being said I want to attempt to keep this a bit more technical and informative.

Is it true what I have been told? They say that if you set up a net under the cliff you can become rich because people just throw money over the edge. And is this cliff located on the coast or is it over land. That makes a huge difference in setting up the net. Also a specific location of said cliff would be great. Thanks for your expertise and time.

I don’t even know what it is… I was wondering the other day but list my train of thought before looking it up. Damn baby brain.

How likely is it to happen? How bad is it projected to be and by when?

Hahaha. That pretty much made my morning, and the thing about the net, brilliant and not too far off the mark.  The “fiscal cliff” is an arbitrary moniker for the pre-established ending point of two major fiscal programs: The first being a conclusion to the recession era stimulus program enacted under President Bush (43) thusly titled the “Bush Tax Cut,” which cut tax rates for income, payroll, alternative minimum tax, dividends and capital gains, medicare reimbursement for doctors, and estate and gift tax (otherwise known as the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003); the second being the automatic reduction in government spending across all sectors, also known as sequestration, that was a byproduct of the 2011 “Super committee’s” inability to reach a sweeping fiscal bargain (also why I may have the small chance of being out of work.) As a background, the “Bush Tax Cuts” were set to expire in 2010, but were extended for two more years under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 as the country was going through yet another recession, with President Obama and congress feeling it necessary to continue these programs, set to expire December 31, 2012.

That is a good question, inasmuch as it speaks to how it is being portrayed and is not to uncommon to hear someone ask it. The “Fiscal Cliff” is not an ‘it’ as much as it is a collection of activities projected. Using the previous paragraph as a base for this statement, it is the common assumption that the cuts, in line with the re-establishment of tax rates meant only to be temporary, will cause two simultaneous reactions: unrest in the marketplace in the form of investor sell offs (to capitalize on the lower cap gains rates) and stock sell off based on an inability to project economic activity based on; the effect that the shifting alternative minimum tax and the increase of payroll and income tax rates have on consumer activity (notwithstanding the fact that January+February are the two worst retail months of the year.) To summarize, the cliff isn’t real, until it is, as of now it is a worst case projection meant only to aide in newscast viewership and political grandstanding.

To answer the second half of your question, no one really knows (see above.) It could be really bad in the most worst scenario, or it could be acute, limited only to those who it directly affects. In my estimation, it will be somewhere in the middle as direct economic policy regression is never very fun as it limits the transition time. What it won’t do is wreck the economy in the long run, as policy normally has very little to do with overall economic activity. People will adapt, money will be spent, and much will be made about what amounts to very little.

Read it, shared it but what about people with investments like 401k’s? Should they redistribute out of the stock market in case of a sell-off?

Good question, and a great addition to the blog!

401Ks are generally considered long run investments. A healthy 401K is well distributed to alleviate undue risk, even in this case. I will use my own as an example as I cannot specifically state a case based on information I do not know. I make this point, as the answer will differ per your plan fiduciary.

As of right now I have my 401K contributions deposited into the federal “L” plan, which is a progressive lifetime investment. Basically, what that means is, as I grow towards retirement age, my contributions shift from being deposited into high risk / high reward mutual funds to more “blue chip” based mutual funds (ultra-low risk / low reward) (disclaimer: I love this plan). Not only am I expecting a short term loss, but I understand that over the lifetime of my plan this won’t be the first one to occur. That being stated, this is a short term loss only. In the long run, most high-yield 401Ks will earn at rates much higher than the rate of inflation (normally 15-17% over 3%), with much of the shock being mitigated by the fact that a 401K is basically a mutual fund with specific tax benefits, (basically tax free deposits). To the best of my knowledge this was not included in the original 2001/2003 stimulus package, nor in the 2010 iteration and will also be protected in the long run by any sell off because most 401Ks are well distributed. If your plan isn’t, this is a breach of fiduciary responsibility and you may want to contact a lawyer.

To sum, in the short run it may look bad, but only in the short run. In the long run you will end up at, or near, where you want to be at retirement. This is all predicated on the belief that the dollar will still be the currency of course, but I believe that to be true for, as much as they test my patience, I still have faith in the legislative branch of the U.S. Government.

Matt, what’s your take on a Roth 401K?

Two in one hand, half dozen in another haha. Really it’s about whether or not you want taxed before or after the age of 59.5. It’s a hedge on the income tax rate that it will be lower now, than it is in the future. Applying this towards the current discussion…

If you believe that your disbursements at 59.5 will be at a particular level where you believe that the income tax rate will be higher than the current rate, than a Roth IRA based 401k is for you as you are willing to accept the tax on your IRA deductions now. If you believe the latter, that tax rates now, are higher than they will be in the future, and that compounding interest on non-taxed contributions will create a larger long run income pool for retirement, which you will be happy in being taxed on rates you estimated will be lower or flat, than a traditional IRA is for you. Hope that helps!

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