Advisers must be flexible during debt limit impasse

THE IMPASSE IN WASHINGTON over the debt limit, and longer-term, over what to do about the federal deficit and the nation’s growing debt has placed investors and their financial advisers in a difficult position.

No one can have much confidence in long-term financial plans, given the extraordinary level of economic uncertainty that the lack of action on these issues produces.

Investors and their advisers should be prepared to build maximum flexibility into their financial plans until the situation becomes clearer, which, most probably, won’t be until after the results of the 2012 elections.

As shown by the debt limit impasse, the two political parties are locked into opposing positions on how to end the federal government’s debt addiction. Simplistically, Democrats want most of the weight borne by tax increases, and Republicans want the deficit reduced mainly by spending cuts.

Some minor compromises on each side might end the debt limit stalemate between now and August, when the Treasury will run out of options for meeting interest payments on the debt.

However, a long-term solution to the budget deficit is unlikely to be negotiated until after the results of the 2012 elections become clear, because the two parties will campaign on their different prescriptions.

President Barack Obama and the Democrats missed an opportunity to lead on the issue and to put the Republican Party in a difficult position by failing to endorse the report of the National Commission on Fiscal Responsibility and Reform, known as the Simpson-Bowles Commission, which Mr. Obama appointed.

The commission proposed tackling the deficit with both spending cuts and tax increases, with two-thirds of the deficit reduction coming from spending cuts and one-third coming from tax increases.

It also proposed eliminating exemptions and deductions in the tax code, and reducing tax rates across the board.

If Mr. Obama had embraced the report, Republicans would have found it difficult to refuse it as a starting point for negotiations because it was a bipartisan commission. To have resisted, if he had been willing to accept the cuts in federal spending that the commission proposed, would have appeared merely obstructionist.

Subsequent negotiations, which probably would have been wrapped up before the beginning of the election campaign, would have clarified what tax increases were coming and how large they would be.

As it is, not only investors but business owners, large and small, must plan in an environment not just of risk, which is one in which you can attach probabilities to possible outcomes, but in one of uncertainty in which so little is known that probabilities can’t be attached to possible outcomes — a much more difficult proposition.

If Mr. Obama wins re-election and the Democrats gain seats in the House and Senate, by 2013, there no doubt will be significant tax increases, initially on couples who earn more than $250,000 a year and individuals who earn more than $150,000. Later, the tax increases likely will reach further down into the middle class, as increasing taxes only on “the rich” won’t be enough to cut the deficit as much as it needs to be cut.

As The Wall Street Journal pointed out recently, taxing every penny away from the top 1% of taxpayers would cover only a little more than 50% of this year’s $1.65 trillion deficit.

On the other hand, if the Republican Party should win the presidency and/or gain seats in the House and Senate, the tax increases will be smaller, but tax increases there will be, because spending cuts alone won’t solve the problem. The worst outcome for the economy and investors would be for an election that left the two parties approximately where they are now.

Financial planners and their clients, therefore, should pray for a clear decision in the 2012 election and, in the meantime, keep plans flexible.