One Fiscal Cliff Down and Three More to Go

As predicted last month, the dreaded fiscal cliff was averted, but only temporarily. It was also suggested that an 11th-hour budget deal would be a “small ball” solution, and so it turned out to be.

The results are in and, if anything, that forecast was overly optimistic.

Tax rates for those making more than $400,000 — $450,000 for married couples — will go up to 39.6 percent and the payroll tax goes back up from 4.2 to 6.2 percent.  Everyone got a tax increase, but the additional revenues do not come close to bridging the nation’s budget deficit. The marginal rate increase on “wealthy” Americans garners only $62 billion a year. In fact, the legislation actually increased spending after being larded up with pork for, among other things, NASCAR and the motion picture industry.

The Congressional Budget Office has estimated that the legislation the president signed Jan. 2 would increase the deficit by nearly $4 trillion over the next 10 years.  Much was left undone as no spending cuts were made. Further, it sets the stage for three more fiscal cliffs that Congress and the White House must negotiate in a very short period.

The first cliff is the need to raise the debt ceiling sometime in late February.

In fact, the United States has already exceeded the debt limit, and the U.S. Treasury is taking action to slow outlays and make other adjustments to keep the nation from exceeding the legal ceiling until sometime in February. At that time, the debate on increased revenues will be taken up once more. The target this time will be a battle between increased revenues from adjusting the tax code — such as further reducing deductions for high-income earners — and cuts to entitlement programs.

The second cliff will be what to do about sequester.

The legislation postponed the effective date of automatic across-the-board budget cuts to federal spending until March 1. Whether this will be settled in the February battle over the debt ceiling remains to be seen. Sequestration, under the Budget Control Act of 2011, calls for $1.2 trillion in discretionary spending cuts over 10 years — half to defense and half to civilian agencies. It would take the defense budget to the neighborhood of $470 billion per year from a current spending level of $536 billion — a drop of some $66 billion.

The third cliff will be the March 27 expiration of the continuing resolution for the fiscal year 2013 federal budget.

On the surface, it would appear that the need to pass a 2013 budget, address sequester and increase the debt ceiling are pieces of the same package, but it is anyone’s guess how, and in what sequence, all this will be resolved. 

A key consideration will be the balance between further revenue increases and spending reductions — either through cuts on the discretionary side or through adjustments to mandatory spending on entitlements.

Whatever the outcome, it is almost certain that defense will have to surrender additional revenue, perhaps another $10 billion to $20 billion per year.  The base budget will end up in the neighborhood of $505 billion to $515 billion.

It would have been hard to have intentionally constructed the mess that we now confront. All of the needed and really difficult decisions have, once again, been punted down the field. And there is no outline or any type of consensus as to how an agreeable solution or meaningful way forward is to be achieved.

In the meantime, the president Jan. 3 signed the 2013 National Defense Authorization Act (NDAA). He took exception to provisions on Guantanamo Bay prisoners, a conscience exception for chaplains and military members on gay marriage, and significantly, on provisions that block health insurance increases for retired service members. Expect this latter issue to be raised during the coming battles associated with the three cliffs.

The NDAA is worth a read as it has a number of winners and losers.

One significant outcome is that all the changes to depot-level maintenance and repair that were enacted in the fiscal year 2012 NDAA have been repealed. This puts the policy back where it has been for some time, and while welcome, it does nothing to solve the issues surrounding the 50-50 split of depot work between the public and private sectors.

Another outcome deals with allowability of contractor compensation. The NDAA did not change the present limit, but directed a report to Congress that details numbers of contractors who exceeded pay levels of certain public sector employees. The report must provide numbers and duties of those in targeted exception categories.

More to come in 2014 on this one. 

Finally, the one-year extension of limitation on the aggregate annual amount available for contract services was dropped, a big win for industry.

All of the foregoing nothwithstanding, defense will have to deal with painful adjustments.  Some of the major systems that have been slipped to the right — including the F-35 Joint Strike Fighter, the Ground Combat Vehicle, a new amphibious vehicle for the Marine Corps and a long-range bomber for the U.S. Air Force — will have to compete for a decreased procurement budget, no matter what.  And with a further reduced defense base budget, more force structure cuts can’t be far behind. 

All in all, the NDAA had more wins than losses, but some of the real issues haven’t yet gone away. They were just postponed.

One way or another, something will have to be agreed upon by March 27 to avert a government shutdown. One wonders how much further the proverbial can will be kicked down the road before major adjustments are forced by circumstances beyond the control of the U.S. government.

With the Federal Reserve spending — or rather creating money to spend — $85 billion per month to buy up mortgage-backed securities and Treasuries, the day of reckoning has been delayed. But interest rates can’t be held near zero forever. A future crisis, may be in the bond market, could force a solution, but it would be better to begin to step up now, before disaster strikes and demands more unpalatable solutions while there are still viable choices available to be made.

Topics: Defense Department, DOD Budget