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A Look Over The Edge Of The Fiscal Cliff

Can we hope for a soft landing if we tumble over the fiscal cliff?

I think so, but we’d better buckle our financial seat belts anyway, because the next few months are going to bring us a bumpy ride politically — and perhaps financially, as well.

Unless there is action in Washington, most Americans face higher taxes in 2013. Big cuts will automatically hit defense and most social programs, though a few especially sensitive items, such as Social Security, are exempt. Many economists believe the combination will reverse the fragile economic recovery and trigger a new recession during the first half of 2013.

A brief recession might not be a bad price to pay for halving the federal budget deficit, as the scheduled changes provide, but with unemployment stuck above 8 percent in an election year, leaders in both parties say they want to act in time to prevent the automatic spending cuts and tax hikes from taking effect. The coming months will bring a major clash over exactly what to do.

To complicate matters, the Treasury is again beginning to crowd the legal ceiling on federal debt. Just as in the stalemate that dominated headlines in mid-2011, it is a foregone conclusion that the ceiling will be raised, but GOP deficit hawks are likely to again use the debt limit as leverage to force deeper spending cuts than Democrats and some other Republicans want.

The action will begin in earnest on Nov. 7, the day after Election Day. Regardless of what the voters decide, President Obama will remain in office until January, and a lame-duck Congress will return to Washington to deal with a huge pile of unfinished business that includes the fiscal cliff and the debt ceiling.

Democrats will push to let the Bush-era tax cuts lapse for upper-income households. They also are likely to try to roll back the $5 million per person exemption for gift and estate taxes, and to raise the current top gift and estate tax rate from 35 percent to 45 percent or higher. Republicans want to continue the current tax rates for everyone.

A victory by Mitt Romney in November would probably ensure that the Republicans would prevail in the tax fight. The only way Democrats would be able to raise tax rates on higher-income households would be to let the Bush-era rates expire for everyone. Democrats would have the voting power, at least in the Senate, to do that, but they have shown no appetite for raising taxes on middle-income voters.

Conventional wisdom holds that an Obama victory would let Democrats win the tax-rate battle. I am not so sure. Obama likewise has no appetite for a tax increase on most American households, as he showed in his tax compromise with Republicans (in a Congress that had Democratic majorities in both houses) in 2010. Republicans will also have the debt-ceiling card to play.

I expect that an Obama victory will mean either a stalemate on taxes that will continue at least into early 2013, or some sort of tax compromise with Republicans that will extend current rates, or something close, through 2013. One exception is that higher tax rates on investment income for upper-income households, which are part of the health care reform law, are likely to remain in any compromise with a re-elected President Obama.

Tax legislation tends to emerge from lame-duck Congresses at the eleventh hour, often with provisions that have seen little or no public discussion. We are likely to be stuck with major questions about near-term tax policy until very close to the end of the year, or beyond.

I doubt that Democrats can get the tax increases they seek, but I believe affluent taxpayers should act as though all of the scheduled increases will happen until we know otherwise. A good general strategy would be to accelerate some income into 2012 to be taxed at this year’s rates, if that income would otherwise be recognized in 2013. The generous gift tax exemption also might go away, so there can be a lot of value in moving wealth to younger generations while the exemption is available.

Beyond the near-term deadlock between the parties, the campaign season has actually elicited a certain consensus about the need for a tax code overhaul and the general form it should take: lower tax rates, especially for corporations; fewer deductions and credits, especially for higher-income households; and possibly some changes in the way cross-border activities are taxed to encourage American manufacturing and exports.

A Romney victory would probably bring a relatively quick agreement to extend the status quo for a year or two while a broader overhaul is considered. An Obama victory might yield the same result. Together with a reasonably efficient resolution of the debt-ceiling extension, this would avoid taking us over the fiscal cliff altogether.

Failing that, a brief excursion into a world with higher taxes and less government spending will at least focus the nation on the reality that the current course of repetitive trillion-dollar deficits is unsustainable. If deadlock means bringing the federal budget under reasonable control, even at the price of a short-term economic slowdown, it will not be the worst that could happen.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.