Breaking Down the Debt-Ceiling Compromise

The last-minute debt-ceiling compromise — signed into law on August 2 as the Budget Control Act of 2011 — was the product of a contentious congressional debate that set off a flurry of reactions from investors, Standard & Poor’s, the Treasury Department, and the Federal Reserve.

Despite this frenetic activity, the key provisions of the compromise received less attention than they might have under calmer circumstances. As an investor and taxpayer, you may want to learn more about the new legislation and what to expect over the coming months.

Quid Pro Quo

The fundamental concept behind the compromise was that increases in the debt ceiling would be balanced by equal or greater reductions in federal spending. This balance is defined in the legislation, but many details have yet to be decided.

The law specifies that the debt ceiling may be increased in three steps by a total of $2.1 to $2.4 trillion.¹ The first increase of $400 billion went into effect the day the act was signed, averting the imminent threat of a federal default.² A second increase of $500 billion may occur in late September unless Congress votes against it and overrides a presidential veto.³

This combined $900 billion increase in the debt ceiling is scheduled to be balanced by a $917 billion deficit reduction over the next 10 years, primarily by capping spending across the board on security and non-security programs. (Security programs include Defense, Homeland Security, Veterans Affairs, nuclear security, and intelligence activities.) Expenditures on entitlement programs and the wars in Afghanistan and Iraq are not included in these reductions.⁴

After these first two increases are in place, the president can request a third increase when the federal debt approaches the new ceiling. The amount of this increase will depend on certain actions of Congress over the next few months.⁵

Trillion-Dollar Challenge

The Joint Select Committee on Deficit Reduction — a 12-member bipartisan group of legislators — is charged with the challenging task of proposing at least $1.5 trillion in deficit-reduction measures. This “supercommittee” must vote on a plan by November 23, 2011, and Congress must accept or reject the plan by a simple yes or no vote by December 23, 2011.⁶

If the committee cannot agree on a proposal or if Congress rejects its recommendation, a minimum of $1.2 trillion in spending cuts will be triggered automatically — to be spread over nine years, from 2013 to 2021, and balanced evenly between security and non-security spending. Social Security and Medicaid would be exempt, and reductions to Medicare spending would be limited to 2% annually.⁷

These “trigger cuts” would not go into effect until January 2, 2013, which gives Congress another year to negotiate the details.⁸

Balanced Budget Amendment

The legislation also requires that Congress vote on a balanced budget amendment by the end of 2011. If they approve an amendment and submit it to the states for ratification, the third debt-ceiling increase would be $1.5 trillion. If the amendment is not approved, the increase would be between $1.2 and $1.5 trillion, depending on the amount of savings that comes out of the deficit-reduction process.⁹

Tax Mystery

One key aspect of the compromise that has received little attention is that all budgetary assumptions are based on the Congressional Budget Office’s March 2011 baseline projection, which assumed that a number of tax reductions enacted during the last decade will expire at the end of 2012. If the tax reductions are extended, additional spending cuts would be required to offset them, and half would come from security/defense spending.¹⁰

It remains to be seen how Congress may address this issue, but it might be wise to anticipate a return to pre-2001 tax-law levels in 2013. This may include higher personal income tax rates, less generous provisions for federal estate taxes, lower exemptions for the alternative minimum tax, and higher capital gains and dividend taxes. Be sure to consult with your tax professional before taking any specific action.

It’s also unclear how the compromise might affect the investment climate. A reduction in federal spending may affect certain sectors negatively; however, any positive steps to control the budget and reduce the national debt could stimulate overall confidence in the U.S. economy.

For now, it seems unlikely that the debt-ceiling agreement would require any near-term investment actions on your part. However, as details of the compromise continue to develop, it might be helpful to keep an eye on activities in Washington. As always, we are available to discuss any questions or concerns you may have.

1, 4, 7, 10) Congressional Budget Office, 2011
2) U.S. Treasury Department, 2011
3, 5–6, 8–9) Congressional Research Service, 2011

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.