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The Debt Ceiling Dilemma

What to watch out for as the debate continues

As if the summer hasn’t been hot enough, the topic that has Washington, D.C. boiling over is the debt ceiling dilemma. Over the past few months, Congress and the Obama administration have been debating what most people would agree is an undebatable issue—whether to raise the limit by which the Treasury Department may borrow to meet its budgetary obligations. Currently, the debt ceiling is statutorily capped at $14.3 trillion, an amount that was actually surpassed in May. Congress and the White House have until Aug. 2 to reach an agreement to raise the debt ceiling. Failure to do so could have disastrous consequences for the U.S. and global economies, according to Treasury Secretary Timothy Geithner, Federal Reserve Chief Ben Bernanke, key officials in Washington and even prominent business leaders.

Possible Consequences

Although a few Republicans have expressed their doubt that inaction on the debt ceiling issue would result in such dire circumstances, most lawmakers take the opposite view. During last Wednesday’s testimony before the House, Bernanke warned that inaction could result in a downgrade in credit ratings on U.S. debt and higher interest rates that could potentially cause another major crisis through the global financial system, similar to what happened when Lehman Brothers folded in 2008. In addition, there could be cuts to services and payment of benefits to U.S. citizens, including cuts in Social Security, Medicare and veterans benefits. After markets closed last Wednesday, Moody’s, a credit rating agency, announced that the continued deadlock over the debt issue has put the United States’ AAA credit rating in question and that default could lead to a credit downgrade.

The Standoff

Despite the looming Aug. 2 deadline, there has been a standoff on this issue between both sides for months. The Republicans insist that an agreement to raise the debt ceiling must be accompanied by a spending cuts package. They argue that over the past few years, government spending has gotten out of control, resulting in a fiscal deficit of about $1.3 trillion in 2010, about 9 percent of gross domestic product (GDP). This was the second highest percentage of debt to GDP since World War II. (In 2009 the federal deficit was about 10 percent of GDP.) The Democrats have agreed to certain cuts, but are unwilling to yield to Republicans’ proposals without tax increases.

The Gang of Six

As the debt ceiling issue came into play a few months ago, the Republicans announced that they’re opposed to increasing the debt limit without addressing what they perceive as out-of-control spending and would agree to raise the limit as long as there were corresponding budget cuts. A group of senators from both parties led by Vice President Joe Biden have been meeting over the past few months to discuss budget cuts and savings agreeable to both parties. In general, “The Gang of Six” have come up with $2-$3 trillion in budget cuts, but this hasn’t garnered the overwhelming support of many in Congress, with some Republicans complaining that the cuts don’t go far enough and some Democrats arguing that the cuts are too deep and unfairly affect the middle class.

The Ryan Plan

Representative Paul Ryan (R-Wisc.) also proposed a solution, “The Ryan Plan,” which would provide savings through Medicare cuts and reforms. This plan received substantial support within his party, but was criticized by many Democrats, as many politicians are hesitant to touch entitlements while others believe entitlement reform is necessary for long-term deficit changes.

Cut, Cap and Balance

Recently, House Republicans offered a third plan that has become quite popular. The “cut, cap and balance” plan calls for immediate cuts to the 2012 budget, a limit on federal spending and the passage of a Balanced Budget Amendment that would include an 18 percent of GDP spending cap and supermajority requirement for any tax increases.

The Democrats’ Plan

The Democrats are also pushing to come to an agreement to raise the debt ceiling, but they are wary of allowing too many spending cuts without tax increases and revenue raisers. President Obama has insisted that the Bush tax cuts that are set to expire in 2013 shouldn’t be extended to families who make $250,000 or more and that tax rates for these “wealthy” Americans should return to or be close to the 2000 tax rates. Raising tax rates on the wealthy is expected to raise only $700 billion over the next decade, the Congressional Budget Office reports, and eliminating the Bush tax cuts on everyone could generate revenue to trim the deficit by about $3.7 trillion over the next decade. The president has also proposed eliminating certain tax loopholes for corporations and oil companies, and changing certain entitlement programs. On July 11, , President Obama proposed a $4 trillion package that included cuts in spending, entitlement reform and tax increases.

The McConnell Plan

This was followed by a plan offered by Senate Minority Leader Mitch McConnell (R-Ky.), which would give the president incremental authority to raise the debt ceiling three times between now and 2013. Each time the president requests an increase in borrowing, he would also have to offer a list of spending cuts equivalent to those installments. Thus far, this plan has been met with mixed reviews on both sides.

Beyond the Debt Ceiling Debate

With so many proposals in play, how can we guide our clients through the confusion and offer consistent advice? First, taxes will continue to be an issue especially as the 2012 election heats up. It’s unlikely that any agreement over the debt ceiling will include the income tax breaks that the president wants, but the elimination of the Bush tax cuts for the wealthy will continue to be a major talking point for the president during his bid for reelection.

Entitlement reform, once a taboo topic and viewed as politically unpopular in the past, has now taken a front seat in deficit and budget talks. As the Social Security Trust reports that it could be unable to meet its benefit obligations by 2037 and as the present version of Medicare continues to be a burden on the system, politicians will finally have to make tough decisions on reform, especially since entitlements encompass about 60 percent of annual federal spending.

Finally, watch for proposals dealing with other revenue raisers, such as whether to close corporate tax loopholes (which the Democrats want) or to lower the overall corporate tax rate (which Republicans favor); whether to eliminate certain income tax deductions such as charitable deductions and mortgage interest deductions; and whether to eliminate subsidies and tax breaks for big oil companies and encourage “clean energy” investment.

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