More fiscal challenges on the horizon

Legislation approved by Congress last week to avert hundreds of billions of dollars in tax increases and spending cuts may turn out to be the easy part of addressing the country's fiscal challenges.

By the end of next month, lawmakers will have to grapple with raising the debt ceiling.

During the same time frame, they also will have to decide what to do about the $110 billion in automatic spending cuts that they delayed for two months as part of the so-called fiscal cliff bill. In addition, the spending authority that keeps the government running will expire in March.

Even though the fiscal cliff measure did end Bush-era tax cuts for households earning more than $450,000 a year — bumping their rates to 39.6%, from 35% — it enshrined in the tax code the lower Bush rates for everyone else.

The measure makes permanent a capital gains and dividend rate of 20% for households making more than $450,000 annually and 15% for those below that level. It also adds to the tax code the alternative-minimum-tax exemption and indexes it to inflation, protecting nearly 30 million Americans who would have been hit by that levy this year.

The bill sets an estate tax rate of 40% with a $5 million individual exemption, a rate increase from 35% but one that is much lower than the 55% rate and $1 million exemption that would have gone into effect if the Bush tax cuts had expired.

The bill offered enough tax goodies that it was a vote with which many lawmakers were comfortable. Even at that, the process of hammering out the bill was fraught with political tension and featured a frantic scramble to beat the deadline on New Year's Eve.

MORE TO COME

Yet last week's legislation for the most part ignored much tougher decisions that have to be made to reduce the more than $1 trillion annual deficit and the more than $16 trillion federal debt, the primary reason why 151 House Republicans revolted against the bill.

“Now that we have to deal with the spending side of it, it's going to be even more difficult,” said Neil Simon, vice president for government relations at the Investment Adviser Association. “It's going to be a rough start for this new Congress.”

Investment advisers are bracing for things to get worse in Washington.

“We have another drama coming up,” said Leon LaBrecque, managing partner and founder of LJPR LLC, a wealth management firm. “I expect that to be ugly.”

And continued squabbling in Washington will put pressure on Wall Street.

“It's quite annoying, but we're in for another full quarter of uncertainty, where the capital markets are being influenced by these outside political factors,” said Jerry Miccolis, chief investment officer at Brinton Eaton Wealth Advisors.

Within minutes of House approval of the fiscal cliff bill last Tuesday, President Barack Obama was already hunkering down for a fight over lifting the debt ceiling.

When the U.S. borrowing authority ran out Dec. 31, Treasury Secretary Timothy Geithner took steps to extend it for two months.

“We can't not pay bills that we've already incurred,” Mr. Obama said. “If Congress refuses to give the United States government the ability pay these bills on time, the consequences for the entire global economy would be catastrophic.”

Mr. Obama has no intention of giving quarter to Republicans on deficit reduction.

AVALANCHE OF SPENDING

“Cutting spending has to go hand in hand with further reforms to our tax code so that the wealthiest corporations and individuals can't take advantage of loopholes and deductions that aren't available to most Americans,” he said.

The lawmaker who hammered out the fiscal cliff bill in negotiations with Vice President Joe Biden warned Mr. Obama that Republicans will be turning to deficit reduction with a vengeance.

“The president got his revenue. Now it's time to turn squarely to the real problem, which is spending,” Senate Minority Leader Mitch McConnell, R-Ky., said in a floor speech last week.

“We cannot agree to increase that borrowing limit without agreeing to reforms that lower the avalanche of spending that's creating this debt in the first place,” he said.

The exchange between Mr. Obama and Mr. McConnell is perhaps an understated harbinger.

“We expect Republicans will not give in anymore on revenues, and Democrats will resist entitlement cuts,” Brian Gardner, senior vice president for Washington research at Keefe Bruyette & Woods Inc., wrote in an analysis last week.

In the summer of 2011, the Obama administration and Congress agreed only at the last minute to extend the debt ceiling, while also approving a bill that set into place the $1.2 trillion in domestic-spending cuts over 10 years that now have been delayed by two months.

Unlike the fiscal cliff bill, which contained tax rates that could be retroactively reduced if Congress missed the Jan. 1 deadline, violating the debt ceiling potentially could lead to an immediate downgrade in U.S. bonds.

“Once you default, you can't undefault,” Mr. Miccolis said. “It's on your permanent record, as they say in school.”

POLITICAL COMITY

The higher stakes with the debt battle have advisers hoping for more political comity in Washington than seen over the past few years.

“The country is bankrupt; that's what we have to focus on,” said Robert Martinelli, owner of Guardian Wealth Management. “It's going to take a lot of leadership, and a lot of people feeling some pain, to get through this.”

That approach, however, is rare in Washington.

“It seems politicians are more interested in positioning than in solving problems,” Mr. Martinelli said.

Mr. Miccolis agrees.

“They've kind of trained us not to rely on them,” he said of lawmakers. “It seems like our representatives spend way too much time assigning blame for lack of action rather than getting something done.”

But Washington has to rise to the occasion because congressional action to reduce the debt could dictate long-term investment performance.

“Wrestling with the deficit and addressing Medicare and Social Security costs, and the rate of increase of those costs over the next 10 to 20 years, makes or breaks our economy, not the fiscal cliff,” said Scott Moser, chief executive of Moser Wealth Advisors PLLC.

Congress will provide a hint of whether it has the wherewithal to tackle those issues over the next two months.

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