A plan to rein in spending is needed

Financial advisers can cheer on behalf of some of their clients — individuals with annual income below $400,000 and couples below $450,000 — but they shouldn't cheer too loudly or too long. Congress and President Barack Obama wrestled mightily on the edge of the fiscal cliff, but instead of stepping away from it, they merely stepped down to a lower ledge. They now will continue to fight on the edge of disaster for at least another two months. Although they managed to resist the pressure of looming tax increases and spending cuts that they designed to address the nation's deficit and long-term-debt ills, compromising only on taxes, they thus kicked the tussle over spending cuts down the road. In fact, the deal reached at the post-11th hour actually increased spending by extending unemployment benefits for a year, blocking a 27% cut in Medicare payments to doctors and renewing several business tax breaks.

LITTLE REVENUE

What's more, the compromise on taxes — the increases on high income — will produce little additional revenue for the government. The result is that the country will relive this sorry spectacle when Congress has to act to raise the debt ceiling. In one corner are Republican leaders, who have warned that they will hold the debt ceiling ransom to force meaningful cuts in federal spending and entitlement reform. In the other corner is Mr. Obama, who has said that he won't negotiate over the debt ceiling. Unfortunately, even the spending “cuts” that the Republicans are seeking aren't cuts in the sense that the average taxpayer would recognize, because the federal government uses what is known as “baseline budgeting.” Baseline budgeting works like this: Federal budgeting assumes that the fiscal 2014 budget will begin with the fiscal 2013 budget and automatically adjust it for inflation and population growth. That is, fiscal 2014's baseline budget would be fiscal 2013's budget, plus inflation, plus population growth. For example, if inflation were 2.5% and population growth 2%, the baseline budget for fiscal 2014 would be fiscal 2013's budget plus 4.5%. That budget wouldn't be viewed by Congress or the president as a budget increase. Only growth above that rate — in either the overall federal budget or the budget of any federal government department — would be considered an increase. Similarly, if the budget for the government or a department in-creased by less than 4.5%, that would be considered a budget cut. What few spending cuts the president has offered in the negotiations appear to be cuts from the baseline, not absolute cuts. For most taxpayers, if their pay increase one year were 4.5% and the next year it were just 4%, it would be a disappointment, but it wouldn't be a pay cut. Only if the pay actually were lower than the year before would it be viewed as a pay cut. To be sure, the needs of some federal government departments might justify an increase of the baseline or more. But just as surely, the needs of other departments probably justify a rate less than inflation plus population growth. Voters had a chance to provide clear direction to the president and Congress on how they should address the fiscal cliff, as well as the issues of tax increases and spending cuts, but they seemed confused or conflicted. They returned the president to office, signaling that they agree with him on tax increases (not surprising since 98% were voting to increase taxes on 2%), while voting to leave the House of Representatives, where spending bills must originate, in the hands of the Republican Party.

DYSFUNCTIONAL GOVERNMENT

Voters' inability to decide on how much money the government should raise and spend has resulted in a dysfunctional government that can't reach an agreement on a plan to balance the budget and address the long-term-debt problem. So all advisers can do is pick their way through the approved changes and try to prepare those clients who will be hit by the tax increases in earned income and investment income. They also should bear in mind that if Congress, by some miracle, seriously addresses the spending problem through entitlement reform and spending cuts, some cuts could hit those higher-income clients. For example, Medicare and Social Security might be means-tested, which means that at the very least, higher Medicare premiums and co-pays could be imposed on higher earners. In addition, failure to reach an agreement over the next two months on a serious plan to rein in government spending will lead to another crisis. But any compromise agreement that results in halfhearted changes in government spending will lead only to weaker financial markets, a weaker dollar and higher inflation. And the longer-term-debt and spending problems will only fester.