The Top Ten 'Fiscal Cliff' To-Do List

Tyler Durden's picture

The schizophrenia in US equity markets (and by correlation all risk markets) is nowhere better highlighted than the last 24 hours of 2% swings in the S&P 500 on nothing more than boiler-plate comments from DC. However, as BofAML's Ethan Harris notes, "the year-end fiscal challenges in the US are more like an 'obstacle course' than a 'cliff' - politicians must navigate about 10 major policy decisions before year-end." We continue to expect a messy multistage deal on the cliff - with some wishy-washy  partial deal late December and more complete resolution (as it will be called) late Spring. We agree with BoFAML's view that until then, we suggest that investors fade the likely “press fakes” of an imminent deal, and brace for downside volatility. It seems to us that the negotiations remains stuck at square one. 

Via BofAML: Cliff Note: Stuck At Square One

Obstacle course

In our view, the year-end fiscal challenges in the US are more like an “obstacle course” than a “cliff”—politicians must navigate about 10 major policy decisions before year-end.


More than three weeks after the election and they are still stuck at the first obstacle: the role of taxes in any deficit reduction agreement. What is the hold-up here? Isn’t there an easy deal that focuses on capping deductions? After all, both parties have been talking about this approach as a way to raise taxes on the wealthy without raising tax rates.

We see three reasons why it is proving very hard to overcome this obstacle:

  1. There is a very big gap in the starting point for negotiations.
  2. The results of this negotiation could set the tone for future deals.
  3. On the surface, capping deductions looks like a painless way to raise revenues, but it looks quite ugly upon closer inspection.

As we have been arguing for more than a year, we expect a messy multi-stage deal on the cliff, with a partial deal in late December and a full resolution only in the Spring. During this period, we suggest that investors fade the likely “press fakes” of an imminent deal, and brace for downside volatility.

A big gap

Any deal on the cliff requires an acceptance of the relative role of revenues and outlays in closing the budget gap. The official positions of the major players are miles apart. President Obama has proposed a roughly $4 trillion 10-year deficit reduction plan that is $1.5 trillion (or 40%) tax increases, mainly from allowing the Bush tax cuts to expire for upper income households. His plan has been roundly rejected by Republicans. They argue that most of the spending cuts are not real: his $4 trillion includes almost a trillion in savings that were already agreed to in the first part of the debt-ceiling agreement and almost another trillion in savings from the winding down of the war in Afghanistan. Stripping those items out, the tax increases become three-fourths of a $2 trillion deficit reduction plan.

By contrast, the two main House Republicans, speaker Boehner and Budget Committee chairman Paul Ryan, have suggested that spending cuts should account for all or the vast majority of the cuts. In his negotiations with the President in 2011, Speaker Boehner was apparently close to agreeing in principle on $0.8 trillion in tax increases, or 20% of a $4 trillion dollar plan. However, that deal quickly fell apart once it began to be fleshed out and vetted with the rank and file members in Congress. Moreover, the plan’s reliance on “dynamic scoring”- raising revenues by stimulating growth—has already been strongly rejected by Democrats. Paul Ryan has offered budgets in each of the last two years that include dramatic cuts in spending - including effectively eliminating all of non-defense discretionary spending - but no increase in taxes.

To reach a deal, the two parties must not only bridge a huge gap in terms of the tax share—somewhere between 0% and 75% - they must also agree on the same accounting system.

A big precedent

The outcome in this initial round of negotiations could set the tone for future deals:

  • What is the percentage split between revenues and outlays?
  • What kinds of revenue increases are acceptable?
  • Will the deficit reduction be “dynamically scored”?
  • Will the austerity be relatively big or small?

Members of both parties feel that their leaders have given too much ground in the past. Democrats were upset when President Obama agreed to extend all the Bush tax cuts. Republicans are upset about extending the payroll tax cut and extended unemployment benefits. For different reasons, neither party was happy with the outcome of the debt-ceiling debate: for some fiscal conservatives, any debt-ceiling increase was wrong and neither party liked the sequester.

For Democrats, there will never be an easier time to raise upper-income tax rates, since they are set to go up automatically at year-end. This is why many liberal leaning politicians and analysts are arguing that it is better to let all the tax cuts expire—go over the cliff—and then offer to restore tax cuts for just low- and middle-income families. At the same time, if they raise revenues by closing loopholes, it will be harder to do comprehensive tax reform later. On Medicare, there are limits to how much payments to providers can be cut without seriously impairing service. Moreover, as we have seen with the “doc fix”, if the cuts are too big, they simply become part of the annual mini-cliff.

Beauty is skin deep

On the surface, capping deductions seems like an easy compromise. It is less offensive to Republicans than raising tax rates. It is favored by Democrats because the vast majority of the revenue increase would come from the wealthy. And it avoids the politically messy business of identifying which deductions should be limited. Deal done. Let’s move on.

Unfortunately, there is no free lunch in deficit reduction - someone gets hurt. As former budget director Peter Orszag argues, the three most important deductions are mortgage interest, state and local taxes and charity1. Of the three, the most discretionary—or easiest to change—is charity.

How hard is the hit to charities? Americans give about $300 billion (2% of GDP) to charities every year. Most studies suggest at least some loss of funding if the deduction is capped. Indeed, a recent literature review shows “some evidence” that limiting “the tax deductibility of individual charitable contributions would fall entirely on charities themselves: taxpayers would cut their gifts by roughly the increase in their tax bill, reducing charities by an equivalent amount.” In other words, if the government collects an extra $10 billion by capping charitable deductions, charitable giving would drop by about $10 billion, or 3.3%.

By contrast, a rise in tax rates for the wealthy might actually increase charitable giving. On the one hand, higher taxes would have a negative “income effect” on charitable giving, as people would have less income to devote to all kinds of spending. On the other hand, higher tax rates create a “substitution effect” where the cost of each dollar of giving is lower. Thus, if the tax rate is 40% instead of 30%, it costs 60 cents to give a dollar to your favorite charity rather than 70 cents. A cap on deductions creates other challenges. As we have noted before, it tends to hurt people in states that voted for President Obama. Looking at the electoral map, states with high taxes and high home prices—such as New York and California—tended to vote for Obama. Raising upper income taxes through tax rates has a uniform impact on high-income families across the country, while a cap tends to target states with higher-than-average deductions.


The debate over deductions underscores many of our themes around the cliff:

  • A long and painful negotiation.
  • A multi-step deal into the Spring is much more likely than a quick fix.
  • Fade the various press fakes around alleged done deals. 
  • Don’t be surprised if deals fall apart once the details are vetted.

The markets have vacillated between complacency and concern when it comes to the cliff. After the Fed easing in the fall, the markets seemed to run out of steam as they started to look ahead to year-end. After the election, there was a quick sell-off when the reality of continued split government sank in. The market then rallied Thanksgiving week, when politicians went home for a full week of vacation. And, in the latest week, they are again in worry mode.

There could be a number of critical moments for the markets:

  • If politicians remain stuck at square one for too long, then, at some point, the markets will lose patience.
  • If some kind of deal can be struck on a combination of tax increases and spending cuts, then the focus will shift to the remainder of the cliff. What is going to happen to the payroll tax cut, unemployment benefits, etc.?
  • Once they decide whether to ignore or extend these items, what about the debt ceiling? The Bipartisan Policy Center now estimates that the government will hit the ceiling in December and run out of gimmicks by February.

Finally, all this needs to be bundled into legislation. Vague agreements in principle will have to become specific. They will have to agree on the overall split between tax increases, spending cuts and “can kicking.” If this “sticker shock” phase goes poorly, politicians could accidentally go over the cliff. In sum: Running an obstacle course along a cliff can be dangerous.

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vinayjha's picture

No matter what Congress do, its late. US will be downgraded and it will be in recession. 

economics9698's picture

We are in recession.  All this “cliff” crap is a dog and pony show for the press to see who get blamed, the “D’s” or R’s.” 

flacon's picture

Warren Buffet hinted that they are not going to resolve the fiscal cliff before January. Buffet believes it really doesn't matter if they don't resolve it. They still have time in January to work out a deal because the world can wait - what else is the world going to do? I hope Mr. Obama enjoyed his vacation last week to East Asia. Congressmen can go home fat and content - eat some Christmas pudding and get drunk on Grey Goose.


DoChenRollingBearing's picture

I read somewhere that the way this will be solved (or not) will be by the proposal that robs Americans of the most money...

Great article, Tyler D, timely and succint!

Bear's picture

Great ... he said real estate is coming back big time

Race Car Driver's picture

> ... get drunk on Grey Goose.

Yes, we should. The Fiscal Cliff - the drinking game.

earnyermoney's picture

Ds blamed for something? LOL

The press will parrot Barry's talking points about the Rs.

I'm hoping for a large explosion at the bottom of the cliff.

jekyll island's picture

Do you ever wonder why ALL the talking heads are saying "taxes" and NO one is saying "spending cuts?"

surf0766's picture

Because they are socialist or communist or progressive republicans

economics9698's picture

Because bankers can print up as much debt as they please.  

A Nanny Moose's picture

No to-do list is complete unless it uncludes "Drink."

A Nanny Moose's picture

apparently I've had too much, hence the misspelling.

tooriskytoinvest's picture

Signs Of Collapse Imminent: Fiscal Cliff, Income Cliff, Obama-care Fiscal cliff On The Horizon, Student-Loan Delinquencies Now Surpass Credit Cards, 2 Million May Lose Jobless Benefits By Next Month, And The US Dollar Is Dying

economics9698's picture

Almost, we need to learn the art of the Molotov cocktail and then we will be Greece.  

toomanyfakeconservatives's picture

No need... Amerikkka is drenched in guns thanks to the founding fathers.

ebworthen's picture


Congressional answers and reasoning:

  1. Debt Ceiling - raise it (why not?).
  2. Bush Tax Cuts - keep them for under $250,000 and rename "Obama Tax Cuts"
  3. Alt. min. tax - get rid of it, because most of the plebes will blame their tax preparer.
  4. Payroll tax cut - keep it, as the sheeple do look at that pay stub.
  5. Sequester - are you kidding?  Military/Industrial complex bribed us too much, cut V.A. budget.
  6. Unemp. Benefits - keep or extend, bread and circuses and WalMart profit must continue.
  7. Tax extenders - re-write some of the tax laws to make them so complex not even H&R Block will understand.
  8. Doc fix - huh?  Documents?  Sure, we can produce some 5,000+ page legislation.
  9. Obamacare - increase copays from 20% to 40%, deductible of $1,000, tax penalties, health records to I.R.S.
  10. Other - kick down the road a decade or two.
Squid Vicious's picture

#8 Doc Fix - lol

I just called him, said he'll be here in about half hour

Yen Cross's picture

Bear? you just dis-appear? WHY?  South America/ Australia/ Africa....  Update Discovery Channel/ You are safe on Z/H brotha!

  Your blog is partially updated, swing trading style?

buzzsaw99's picture

In other words, if the government collects an extra $10 billion by capping charitable deductions, charitable giving would drop by about $10 billion, or 3.3%...


I disagree. Very many people don't itemize. It would hurt but it certainly wouldn't be equal. If the only reason people donate is for the tax dodge then gubbermint might as well give the money directly to charity instead.

Dick Buttkiss's picture

"If the only reason people donate is for the tax dodge then gubbermint might as well give the money directly to charity instead."

As if it would?  You gotta be kidding.

As always, the state can kiss my ass.

BandGap's picture

You're an idiot.

Large donors itemize, trust me. And if you think most people give to get a tax break you're a bigger idiot.


Squid Vicious's picture

#1 - kick the can down the road ... and call it a 'deal'

#2 - raise debt ceiling another trillion, saves us from #2-#10, too painful.

nmewn's picture

My two year "cliff" note says...these are the same bastards (98% of them) who kicked the can last time...I think its time some of your skin was in this game.

I'm thinking an across the board 20% salary, health insurance and pension reduction on all federal employees and a 35% reduction (in same) for elected "employees".

Feel the pain bitchez, it's only fair.

fonzannoon's picture

Nmewn I have it somewhat close. I have a 20% salary cut for all federal employees with a 50% cut in pensions as well as they have to pay 50% of their healthcare costs.

Similar cuts for elected officials with term limits thrown in. Also more importantly a lot of people have to go to jail and more than a few probably need to be hanged.

feel the pain, literally, bitchez.

Yen Cross's picture

 Hey Fonz, I just want to thank you for being so strong through that sandy storm.

 I would like to open a trading account in your family name. We can call it the 'Fonz Account'

  I want to give something back. You could share trading ideas with us. is that ok?

 I could send you a grand/ like paypal or something. I open the Account and sign it off to you.

   You teach your kids how to trade...

fonzannoon's picture

Hey Yen, that is a seriously nice gesture. I am floored. But there is no way I could accept. First off, I got off real easy. I saw some crazy stuff, but for me the whole thing was just a big inconvenience. There are plenty of people who got hit really hard. If you would like to contribute I could find someone who is in a bad spot and maybe you could contribute directly to them somehow. Let's PM offline.

DoChenRollingBearing's picture

^--- Above dialog shows the quality of many here at ZH.

+ 1's!

Likstane's picture

Bullshit! Fonzaznoon never did the home depot drive by with the t-shirt.  We don't really know if he was anywhere near Sandy.  He prob lives in KS. 

nmewn's picture

What I always find amazing is this...we are supposed to believe the fiscal end is upon us if a deal isn't made, but yet...what their time frames?

The negotiations are scheduled around their days off, their vacations (Thanksgiving, Christmas, Air Force One trips to SE Asia etc.). Does anyone see the lights burning in the federal capitol? Anyone notice the lack of urgency on their part? C-Span carrying any mid-night/early morning live debates on the proposals and counter proposals to avoid anyones taxes going up or layoffs at the federal level?


It's just plain old thievery and the thieves are so disinterested they aren't even bothering to appear at the scene of the crime.

Fuck em...impeach all their asses and seize their pensions!!!

fonzannoon's picture

Europe took the whole summer off from their crisis. They had a crisis, I watched it, they took the summer off. That's exactly how it happened. That tells me it's not a crisis, not a real one anyway. It's just theatre.

NickelthroweR's picture

Theatre is all that is left.  I just have a hard time believing that anyone in Washington actually believes that all these promises are going to be kept and everyone is going to get paid.  I think they are just seeing how long they can keep it going.

SeattleBruce's picture

"That tells me it's not a crisis, not a real one anyway. It's just theatre."

It will get worse.  It will be very real.

Bear's picture

Only possible after the fall

Cdad's picture

I keep hearing that the fiscal cliff issue might be solved.  However, I keep waiting to hear how these idiots in DC are going to fix $16.3 trillion in debt...and rising.  I have yet to hear one single credible plan to deal with that problem....and I am talking long term.


Bear's picture

Fixing it in the same way the ECB has fixed Euro ... lie, wait, lie, wait, lie, wait

SeattleBruce's picture

And that's in conjunction with all their banksta friends who... lie in wait... lie in wait...for all their prey.

Yen Cross's picture

 I'm not that terminal/

 Hell, I'm living it! Buy a new "huge  boat" and go Sinbad on shit!

Yen Cross's picture

  Now is the time to short risk/ aud-usd is going to test that 1.04 barrier soon.

  I'm adding to my short position.

jekyll island's picture

How are you playing the trade?

Yen Cross's picture

The $ was overly short, crude and gold sold off ass well.   I'm playing long $ retrace trade vs (gold )/ gonna hedge

short term notes/ 2years...

Moe Howard's picture

I hope they smash Ag & Au down in December so I can load up the truck. Other than that, fuck them.

toomanyfakeconservatives's picture

I will continue exchanging green monopoly money for canned food and bullets right up to the moment the plug gets pulled.

Essential Nexus's picture

I'll take a number 1 please.

SKY85hawk's picture

What are people complaining about?

One side of their mouth says Govt must reduce spending, and the other side says no cuts!
The100 billion dollar cut in DISCRETIONARY spending will not affect the social safety Net.

It will affect lots of 'non-essential' govt employees.
I suspect all these sound bites are coming from people that don't want to suffer like the rest of us have.

How many times have you heard of Fraud and Waste  in Medicare?

The Fiscal Cliff is a good example of the House and Senate actually doing their job.

There should be more of this, or we'll be in as much trouble as Greece and Spain!


optimator's picture

Give legislators five hundred bucks, under the table, for every billion they cut off the budget (only if they pass one).

Problem solved.

SeattleBruce's picture

LOL - that's about what they'd take, and about what they're worth, isn't it?