Possible Cliff Compromise Just a First Step

Jason Stipp: I am Jason Stipp for Morningstar. Stocks rallied on Monday as Congress made progress on cobbling together a plan to avert the so-called fiscal cliff. Here to talk about the early contours of that plan is Morningstar Markets Editor, Jeremy Glazer. Jeremy, thanks for being here.

Jeremy Glaser: Glad to be here, Jason.

Stipp: So we did hear from Congress are making some progress towards reaching some kind of agreement to avert part of the fiscal cliff. What do some of the early contours of that plan look like? They are still, obviously, taking a look at that. Nothing has been passed yet. As we film this, they're going back and forth I'm sure. But what do we know so far?

Glaser: Well, I think that is an important part that we're not exactly sure what the deal is going to look like. But based on reports, we think we do have the basic idea and essentially, Congress is going to deal with the tax portion of the fiscal cliff and kind of worry about their spending cuts and potential changes to entitlement and the debt ceiling later down the road.

So in terms of taxes, they're going to extend the current tax rates for most tax payers except for those who are making a $400,000 or more individually or $450,000 as a family. They are going to see their rates go up to the Clinton-Era levels from before the Bush tax cuts.

Dividend and capital gains rates for those high earners, will go from 15% to 20%, will remain at parity for the rest of tax filers, but certainly it's something that a lot of people – the big question mark is if capital gains as dividends would be treated the same. It looks like that they will be.

The state tax will go to a 40% rate for states over $5 million. It's a little bit more than current rates, but still better than what would have happened if the fiscal cliff completely were to take place. Some changes to the Alternative Minimum Tax, AMT, fixes that potentially, permanently indexes it. So you don't have to worry about changing it every year so that more people don't get caught up in it; changes to Medicare reimbursement, so that doctors will get reimbursed at the same level so-called doc fix, that's in there; some programs to extend unemployment insurance for one to two years, that's not entirely clear on the deal yet either so that folks are still looking for jobs and will get that unemployment and at the payroll tax that had been – the payroll tax cut that had been in place would expire.

There'll probably be a lot of other things in there, some things with the earned income. Tax credits and child credits are other things could be extended for approximately five years. We have to see exactly what comes out of the deal, but definitely a lot of changes in the tax trying to create a more permanent tax code and one that fixes at least that part of the fiscal cliff.

Stipp: So I think that's a key point as we understand the plan right now that a lot of these fixes as far as where they are setting the tax rates are permanent. They are not meant to sunset at an exact time like the Bush-era tax cuts where which later got extended. So does this mean that we really don't have to worry about the tax code? We've got it fixed now if they pass this and that uncertainty is off the table?

Glaser: Unfortunately, that's not the case and I think it's because they haven't dealt with the spending side of the equation yet that we've – maybe taking care of some of the tax issues, but the sequestration which is another big part of the fiscal cliff, which is these mandatory budget cuts and military and discretionary spending are still in place. They are still likely to be in place.

That means that we're going to have to somehow figure out how to handle the sequestration, because it wasn't really designed to ever be implemented. It was put into the legislation at the last minute, during the debt ceiling negotiations and it was there because it was extremely unpleasant for both Republicans and Democrats. No one wanted to see it happen. It was really a sledge hammer that would be seen as so unthinkable on the both sides with kind of have to come to the table and bring and negotiate.

Even if you think that the magnitude of it is the correct amount of spending you'd want to cut, it's probably not the area as you would want to spend, you'd want to cut the spending. You'd probably want to spread it out over more time. You'd want to focus on programs that are less effective, get rid of program – excuse me – focus on getting rid of programs that are less effective, keeping programs that have a greater level of effectiveness. That's something that just can't be done with the current sequestration.

The President is saying that if you want to replace those, you have to replace it not only with spending cuts, but also with new revenue, while the Republicans want to replace it just with spending cuts. If the President wants to have revenue on the table, something he has said over and over again in his press conference today that not only is the revenue we're getting from these tax changes for this deal, we're also going to need to get revenue in order to deal with sequestration; means it's just going to be potentially more changes to the tax code.

It could be the limiting of deductions. It could be moving the higher rates to people who make less than $400,000. We don't know what the contours of these negotiations are going to be, but there is going to be more negotiations on revenues. This isn't over yet until we think about how those spending cuts are potentially going to get replaced. I think that that means that the tax uncertainty although diminished by getting rid – by passing this tax part of the deal potentially passing it does not go away completely.

Stipp: Another big thing that this early deal is not touching, as you mentioned at the outset is entitlement, which is the big area that they are going to have to come to the table on at some point. What's the ramification of this not talking about entitlements here?

Glaser: Entitlements are huge. If you look at the long-term deficit, it's driven by entitlement growth, it's driven by healthcare spending primarily, and there is nothing in this current mini deal that does anything to address those long-term problems with entitlements. If we think about the long-term fiscal health of the country, that's something that's going to have to be addressed. Eventually, there were some hopes early on that they'd be at least able to make some small moves on entitlements as part of our grand bargain, as part of a way of reverting the fiscal cliff. That doesn't look like it's going to happen right now. We'll see if it comes up again in 2013, but that is a big question mark about how those entitlement programs are going to have to change in order to keep deficits under control.

The debt ceiling also will be another really important area that wasn't touched here that we're going to be hearing a lot about and certainly a lot sooner than entitlement reform, because we've already hit the debt ceiling. Secretary Geithner has said that we've already hit that limit. They can kind of move money around from accounts for a while in order to buy some time, but it's not clear exactly how long that's going to take.

Congress is going to have to vote to raise that statutory limit, so that the Treasury can issue more debt. That's going to be a big battle. Both sides are kind of getting ready for that fight. The President is saying he will not negotiate on the debt ceiling. He just wants a clean bill passed. Congressional leaders are saying that they want to have more spending cuts attached to that. That's going to be a big battle and it's one that's just around the corner. So even though we gave this outline of a tax part of the deal and that's certainly a positive for almost all investors, on the flip side, we still have these big fights over the debt ceiling of entitlements over spending cuts in front of us that could potentially produce a lot of volatility and produce a lot of uncertainty.

Stipp: So the volatility for 2013 is definitely not off the table even if they can get this plan passed. If they can't get this plan – this short-term plan on this tax side passed for whatever reason over the next few days, do investors really need to buckle up here might we see some more volatility even in the very short-term?

Glaser: It's difficult to predict what the market is going to do at any given day in any given hour, but it does seem that if no deal is reached, that if they got this close and weren't able to come to terms on a lot of things that there – there was broad agreement on with the exception of raising the tax rates, lot of the rest of the deal, there was some bipartisan consensus on that probably doesn't bode well for working on entitlements, for working on the debt ceiling, for working on getting better sequestration, replacing sequestration with another round of more targeted cuts. I think that is something in the market may not, I think, kindly and it probably doesn't speak well it's the ability of Congress to produce kind of those meaningful changes that are needed to get the fiscal house back in order. I think certainly investors may see some volatility and may have to be able to bear that for quite a while.

Stipp: Alright, Jeremy we'll bring our seat belts, but thanks for helping us guide us through this fiscal cliff with your analysis.

Glaser: You're welcome Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.