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The general feeling at the moment is that the Democrats have the advantage. The election, after all, put Mr. Obama back into the White House, modestly enlarged the party's Senate majority, and gave Democrats small gains in the House of Representatives. But still, Republicans retain a solid majority in the House and have the ability to block legislation in the Senate. Especially since there is dissension within as well as between the two parties, neither side has the power to impose its will on the other. What is more, both sides face tremendous pressure to compromise. If each hopes that the public would blame the other side for failure, the prospect of recession, which would almost certainly accompany a fall off the cliff, simply carries too much risk for most politicians. Even such tough partisans as Senate majority leader Harry Reid (D-NV) and House minority leader Nancy Pelosi (D-CA) have bowed to the imperatives of the moment and have begun to talk in terms of "grand bargains" and "compromise." Pelosi said bluntly, "We want agreement," while Reid decries "brinkmanship."
The biggest cliff issue is the expiration of the Bush tax rates. Republicans want to extend these lower rates for all. President Obama and the left of the Democratic Party insist on keeping the rates low for all but higher-income earners. The president points to the election to claim that the majority of the public is on his side. He has a point, but it is not all his way. At least one-third of the Republican caucus in the House has pledged never to raise tax rates on anyone. Obama knows that his election victory means little to these representatives. Their political careers would end if they broke their vow. Their seeming intransigence raises the risk of failure should the president stand firm on his point, and the president knows that failure would impose considerable pain on his constituents. Taxes would rise on the middle class (as well as the wealthy). Non-defense discretionary spending would suffer more than $50 billion in cuts. Extended unemployment compensation payments would end suddenly, and the burden of alternative minimum tax (AMT) would impose on much of the middle class. Medicare services would weaken, because a scheduled 27% cut in doctor’s fees would prompt many medical doctors to exit the program.
Faced with such an impasse, both sides might well embrace tax reform. Some way to reduce statutory tax rates while at the same time eliminating or capping tax breaks would offer a way out of the awkward impasse on the Bush tax rates. Reform proposals of this sort have found favor at times on both sides of the isle. In the past, Republicans have only countenanced such reforms if they were revenue neutral, but, opening an avenue for compromise, House Speaker John Boehner (R-OH) has already indicated that he would accept revenue enhancers. Even the Republicans who have pledged themselves against voting for new taxes could square increased revenues with their pledge, since tax rates would not rise in a reformed structure.
Right now, the president offers the biggest impediment to the reform solution. Though he has embraced such reform principles in the past, he wants first to impose higher tax rates on wealthier Americans and then negotiate reform from those higher rates. For this reason, he has argued an elimination of deductions or capping them would fail to provide sufficient revenue. "The math," he said, "tends not to work." But analysts on both sides of the political spectrum say that the government could generate considerable revenues in this way. Those analyses have had effect. Many, even within the president's own party, seem reluctant to risk failure for the sake of the administration's two-step process. A centrist group called the New Democratic Coalition has formed within the party. Amounting to at least one-quarter of the Democratic caucus, it has made clear that it wants to embrace the new Republican openness to revenue increases within a reform effort. Combined with the 15 remaining conservative Democrats, the so-called "Blue Dogs," mostly from southern states, this new coalition could add considerable force for compromise.
Similarly, the pressure of the cliff seems to have made Congress more open to entitlements reform. Republicans, of course, built part of their campaign around it. Now, while the Democratic left still rejects entitlements reform out of hand, the pressures of the moment have raised other voices within the party. Some would only permit minor adjustments, but others, led by Senator Dick Durbin (D-IL), would consider bolder ways to contain entitlements spending. Bolstered by work done at the left-leaning Center for American Progress, these new Democrat positions focus on raising the eligibility age for Medicare, means trusting for benefits, introducing competitive bidding for some services, and seeking savings by paying for medical outcomes instead of fee for service. Even President Obama has tipped his hat to such proposals, though only in general. They are, of course far from Republican positions, but still no less a partisan than Senate minority leader Mitch McConnell (R-KY) has characterized them as a basis for compromise.
If such compromises would still leave the country far short of complete fiscal reform, they would avoid the fiscal cliff, or at least the bulk of it. Any combination of entitlements and tax reform, especially with enhanced revenues, would count as sufficient deficit reduction to avoid the automatic discretionary spending cuts, the so-called sequestration, currently built into law and a big part of the fiscal cliff. Tax reform, even if it were to fall far short of ideal, would also sidestep the debate over the Bush tax rates and spare the economy that part of the cliff as well. Congress, having jumped such hurdles, could then easily pass another annual AMT "patch" to block an extension of this particular burden to the middle class. Nor should Congress have difficulty protecting Medicare services by blocking the planned cut in doctors’ fees. Congress has done this so frequently in the past that the legislation has a nickname, the "doc fix." Not only could the economy miss the fiscal cliff this way but also, for those with an optimistic turn of mind, the compromises, jury-rigged as they inevitably will be, could perhaps even lay the foundations of something more substantive.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.