Cliff Resolved - Deficit Set To Explode

In a stunning turn of events the Republican controlled House of Representatives passed the Senate's bill to raise taxes with no cuts to spending. In my post earlier today I detailed the various tax increases, and few spending cuts, that was passed by the Senate. I also stated that:

"There are two big issues with the current bill that will keep it from passing in the House without substantial amendments:

  1. The cuts to spending are too small ($15 billion) relative to $620 billion in tax hikes over the next decade, and;
  2. There are no measures to control future spending.

In its current form the deficit will increase in 2013 as higher taxes lead to lower economic growth. It is not just higher taxes on the "rich" but also on the middle class as the payroll tax cut expires leading to a 2% increase in taxes. The direct cost of the increase in payroll taxes will be roughly $125 billion equating to a drag of 1% on GDP alone. Slower economic growth in 2013, combined with no spending reforms, will lead to an expansion of the deficit in 2013. This is a point that is not lost on the Republican controlled House.

Furthermore, while the Republican Party may have lost the election, the duly elected representatives in the House would like to keep their seats come the next elections in 2014. If they give way to a bill that once again caves to the demands of the White House, as they did in 2011, it is likely they will be replaced by their constituents."

Clearly I was wrong as 85 Republicans, including Boehner and Ryan, defected from the majority and voted for the bill along with a broad majority of the Democrats. However, the battle lines are now drawn for the "debt ceiling" debate in the weeks ahead. The Republicans are clearly stating that they are going to square off with the White House to demand spending cuts to offset the new tax increases.

Under the current bill there is only $1 in spending cuts for every $41 in tax increases. As I stated in my previous article not only will this actually result in a drag on the economy going forward it will also increase the deficit. According to updated information from the CBO the "Fiscal Cliff Deal" carries a $4 Trillion price tag over the next decade.

"The extension of lower tax rates for a bulk of the nation's taxpayers and the addition of a permanent patch to the alternative minimum tax would add roughly $3.6 trillion to the deficit over the next decade, the CBO said. Other individual, business, and energy tax extenders would add another $76 billion. The extension of unemployment benefits would cost roughly $30 billion, and the so-called "doc fix" would tally another $25 billion through fiscal 2022.

The CBO says the budget agreement will lead to an overall increase in spending of about $330 billion over 10 years.

The Committee for a Responsible Federal Budget, an advocacy group that supports broad deficit-reduction reforms, estimates the entire package would increase deficits by about $4.6 trillion over the next ten years compared to current law projections."

By giving into the White House, and raising taxes without a substantive agreement for spending cuts, the Republicans have greatly reduced their bargaining power. They have also likely angered a large majority of their base which will impact their reelection efforts in 2014. Furthermore, this has set up a battle for Boehner's post as Speaker of the House.

In 2011, when Boehner caved to White House demands and pushed to raise the debt ceiling, it created a rift within the Republican party. This latest vote by Boehner to support the current Administration, once again, against the wishes of the majority of the Republican controlled House now puts Eric Cantor in the lead position to challenge Boehner for his post. This could be a significant turning point for the conserative right if this occurs and it is likely this battle could play out quickly before the debates on raising the debt ceiling begin.

While Obama has already thrown down his gauntlet that he has "no intention" of having another debt ceiling fight - that very likely will not be the case. The stakes are higher than ever for the Republicans to counter the tax hikes with offsetting cuts in spending - and the last opportunity to make that stand is during the upcoming debt ceiling debate.

However, while the debate rages in Washington - Wall Street is playing its own game. The interesting thing is that while most economists and analysts argued that going over the "cliff" would have been bad for the economy and the markets - the markets really never seemed to agree. Maybe they always knew that the White House would win. Or, maybe, it is just the global push of liquidty that trumps the debate. Regardless, while the government wrestled for the last several months over its issues - the market rallied strongly finishing out 2013 with a sharp gain and rising 13% for the year. Now, with the passage of the bill this evening, the markets are set to explode higher when the bell rings this morning.

The road is cleared, for now, for the financial markets to rally as the Federal Reserve pumps $85 billion a month in liquidity into the system - it is a "risk on" world. However, don't become too complacent within your investment portfolios as there are several risks that lay ahead. The impact of higher taxes on 80% of Americans, despite claims to the contrary by the Administration, will weigh on economic growth by at least 1% if not slightly more. Secondly, there is still a battle coming over raising the debt ceiling and the depth of the spending cuts coming from that debate could be larger than expected. Finally, Obama has most likely not counted on a negative response by the "small business community" which will be largely affected by this bill. The next NFIB report should be most telling in regards to their confidence and hiring plans. 2013 is already promising to be anything but boring.

Source: Street Talk Live

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