Executives at investment firm Goldman Sachs have repeatedly warned over the past two months of the risk of falling off the much discussed "fiscal cliff." Chief executive Lloyd Blankfein, in an interview with CNBC, stated: “We sure know what the consequence will be and it will be awful.” According to Blankfein, it’s “one of the major ways in which the slow recovery that we have could be completely derailed.” Goldman’s political economist summed up the prospects if President Obama is re-elected and the Republicans retain control of the House, as now appears likely:
A status quo political outcome raises the risk of a game of fiscal “chicken” at year end, in which policy goes “off the cliff” unless one party reverses their long-held position on the upper income portion of the tax cut.
This article probes beyond these summary statements so that the prudent investor can better understand why there is a substantial risk that we will fall off the cliff.
The assumption is that the voters return President Obama and a Republican House to power. President Obama insists that tax rates for the wealthy must go up. He wants to extend the Bush tax cuts for all but the top 2% of income earners when these tax cuts expire at the end of the year. Republicans are unalterably opposed to any tax rate increases, indicating that they will support extension of the Bush tax cuts only if all taxpayers are included in the extension. Last summer, House Republicans refused to extend the cuts for the 98%, holding them hostage to the 2%, and indicate they will do so again if re-elected. Failure to extend the Bush tax cuts for the 98% will create a fiscal crisis. To grasp the depth of the conflict, it is necessary to understand the history and basis of each of these positions and the likely impact of the election.
President Obama first stated his commitment to raise tax rates on joint filers with incomes greater than $250,000 in 2009. He has repeated that commitment several hundred times in campaign settings, interviews, and press conferences – and most recently in the Presidential debates. In the first Presidential debate in Denver, he stated:
... I have said that for incomes over $250,000 a year that we should go back to the rates that we had when Bill Clinton was president, when we created 23 million new jobs, went from deficit to surplus and created a whole lot of millionaires to boot.
Obama’s stance on this issue has been a core focus of his re-election campaign. No theme has been more central. Key to appreciating his current determination on this matter is what happened in 2010. Bob Woodward, in his recently published Price of Power, reports that after agreeing to a two year extension of the Bush tax cuts in 2010 that included breaks for the wealthy, Obama told the House Democratic leadership, “I am drawing a line in the sand after this…. Let’s protect the fragile economy. Come the next round when these things expire, I am holding. Not going to happen again.” In making this commitment to the House Democratic leadership, he was making a commitment to himself.
What drives Obama’s passion for this issue is his belief that the well documented growth of income inequality is damaging the nation and that it is only “fair” that the wealthy should pay a greater share in helping the nation deal with its debt crisis. The Democratic leadership of the Congress has forcefully endorsed Obama’s stance on this issue, fortifying his determination to raise tax rates on the wealthy.
Having stated the position with such frequency and conviction, having made it a core focus of his re-election campaign, he seems highly likely to stand his ground and refuse to back off or compromise.
For Republicans, raising any tax rate is anathema. 279 Republican members of Congress, 95% of the total, have signed a pledge to never raise taxes, commonly called the Norquist pledge after Grover Norquist, the director of American for Tax Reform. The Republican House leadership signed the pledge more than a decade ago and has repeatedly reiterated its commitment to no tax increases. While some Republican moderates/pragmatists have suggested that this pledge does not preclude reducing deductions and thereby increasing tax revenues, GOP congressmen have without exception indicated that they oppose any increase in tax rates. Specifically, they have universally asserted that they oppose returning to the pre-2001 tax rates on incomes above $250,000.
The GOP leadership, including Senate Majority Leader Mitch McConnell, House Speaker John Boehner and other key players such as House Majority Leader Eric Cantor and Finance Chairman Paul Ryan, has rejected any suggestion of compromise on raising rates in their public statements and in private meetings with the White House and senior Democrats – according to Woodward, a total stonewall. Speaker Boehner is reported by Woodward to have told President Obama during their debt ceiling negotiations in earlier this year that raising tax rates for Republicans is a total non-starter and that Republicans would refuse to negotiate if that were on the table.
The commandment “read our lips, no new taxes” has been uttered so long, by so many leading Republicans, it is now deeply embedded in their gospel, essentially an article of faith in a party with a strong fundamentalist constituency. The emergence and impact of the tea party faction of the GOP has resulted in even greater intransigence on this issue. Senator Kent Conrad, Chairman of the Budget Committee summed it up: “Opposition to higher rates has been an obsession with the Republicans since Reagan. It is a ‘holy writ.’” The Republicans will not sacrifice this core principle unless they have no option.
One thing is clear – any sign of softening of their position that tax rates must not be increased would bring a torrent of criticism and opposition activity by innumerable Republican activists and their supporters in the press such as Fox News and the Wall Street Journal.
Bottom line: For Republicans, it has long been an article of faith that tax rates must not be increased. Over the past four years, it has increasingly become an article of faith for Democrats that tax rates for the wealthy must increase – a classic sectarian dispute. Each side is deeply embedded in and passionate about its position.
If the election outcome is an Obama re-election and Republicans retain control of the House of Representatives, little is likely to change in terms of this basic dispute. While Obama may argue that his re-election gives him a general mandate and a specific mandate on raising taxes on the rich since it is at the core of his campaign platform, the Republicans are unlikely to agree. If they retain control of the House and Obama’s margin of victory is smaller than in 2008, Republicans will argue that the electorate rendered a split decision. His re-election simply will not be enough to dislodge them from their decades held opposition to raising tax rates. If anything, the election may marginally increase each party’s entrenchment in its position. Obama may feel obligated to carry out his campaign plank on raising taxes and thereby even less likely to back off that position. The emergence of Paul Ryan as the Vice Presidential candidate may further embolden and strengthen the Republican Party’s stonewalling on the issue of raising any tax rate.
For a number of months, President Obama has stated clearly and emphatically that he intends to veto any extension of the Bush tax cuts that does not eliminate the cuts for those joint filers who have income greater than $250,000. On October 18, Presidential Press Secretary James Carney reiterated that position during a campaign visit in New Hampshire. "The President has long made clear that he will veto an extension of tax cuts for the top 2 percent of wealthiest Americans," Carney said. In reaction to Carney’s comments, House Majority Leader Cantor indicated that the re-election of President Obama would not alter Republican opposition to higher tax rates. House Speaker Boehner and other GOP leaders have labeled Obama's threat a "'Thelma and Louise' economic strategy," referring to the 1991 film in which the lead characters drive off a cliff rather than surrender to police.
Senior White House officials on providing background to several reporters have emphasized that President Obama believes he has the upper hand with the expiration of the Bush tax cuts and will play hardball with the Republicans to force them to agree to increased taxes. They have implied that with re-election no longer an issue Obama will stand firmer and fight harder for his positions.
Republicans have stated that, if they give up on tax rates for the wealthy, they will lose key leverage on any subsequent debt reduction talks. Republicans have been pointing to Obama’s 2010 decision to extend the tax cuts for all income levels and conclude he will relent on his veto threat because of the current economic weakness and his desire to get other concessions on his agenda.
Three escapes routes have been widely discussed: (a) an agreement to raise taxes on those with an adjusted gross income above $1million; (b) a broader bargain to increase tax revenues primarily by sharply reducing deductions and other tax write-offs, often called “tax expenditures”; (c) kicking the issue down the road in order to give the parties more time to negotiate. Each of these options would have to overcome major roadblocks.
Vice President Biden and senior Democrat Senator Charles Schumer have suggested raising taxes on those with income above $1 million. For Republicans, however, it is not a matter of the level at which to reinstate lapsed rates, but the principle that no rate should go up. At this stage, they are unlikely to sacrifice their long held position for such a compromise. President Obama has indicated that he would be willing to consider a broader bargain if it includes a significant increase in income tax revenue, the bulk of which is born by the top 2%. At this stage, the majority of Republicans in the House are almost certain to reject that option as a violation of their “no new tax” pledge. The core dispute remains unresolved. Kicking the can down the road has no apparent appeal for Obama, especially since he would have the momentum of an election win.
Conclusion: There is a significant probability that the Bush tax cuts will lapse, at least for some period.
The Goldman quote at the outset portrays the grim standoff ahead. Both parties now appear to be engaged in a game of chicken. The leaders of each are individuals with strong egos and a belief that the opposition will back off. At the same time, they are pragmatic politicians or they would have never achieved their current roles. What makes the prospects so troubling is the depth of conviction that each side has for its position. Keep in mind there is no middle ground on two core issues: You either raise tax rates for the wealthy or you don’t, and, you either increase taxation of the wealthy or you don’t.
For the prudent investors, this is a time to prepare for turmoil and volatility. Some may wish to ride it out, while others may find a retreat to the sidelines the most comfortable course.
Return to Part 1 of this Newsletter.