A Balanced Solution for the Cliff?

The primary concern for investors remains the ‘fiscal cliff’. Under the worst case scenario of gridlock in Washington, D.C., some $600 billion in tax hikes and expenditure cuts will go into effect in early 2013. Under these circumstances a feeble U.S. economy would go once again into recession.

One negative outcome of all this uncertainty is that U.S. companies, despite rock-bottom interest rates, have hoarded about $1.7 trillion in cash. Judging from the performance of the U.S. markets lately, investors may be spooked by a possible increase in taxes on dividend and capital gains.

On Thursday, President Obama reiterated that he would not roll over tax cuts for the wealthiest Americans. The problem is that implementing the President’s tax ideas do not come any where near plugging the deficit. For example, taxing the rich and getting rid of tax breaks for corporations would only make a dent on the mammoth deficit.

It is in this context that a report by Erskine Bowles and former Senator Alan Simpson assumes center stage. They have suggested a calibrated approach for bringing down the trillion dollar plus annual budget deficit. The two recommend a combination of spending cuts and tax increases.

The duo has suggested reform in five critical areas: trimming healthcare expenses (which may consume as much as 25% of GDP), reforming social security (people are living a lot longer today than at the time when the system was devised), curtailing the defense bill, reforming the tax laws and managing the ever growing compound interest burden on the national debt.

While a solution to the impasse would be the favored approach, we recognize that there is a possibility that a bi-partisan compromise may not be reached. In that case, the Administration may simply claim that the national interest was subverted by the taxes on the rich debate. In any case, following the demise of the Bush era tax cuts, the Administration would get to collect some of the sought-after revenue.

Credit rating agencies must contend with the current uncertainty. Standard & Poor’s Rating Services, a part of The McGraw-Hill Companies, Inc. ( ) currently retains a AA+ local and foreign currency rating. Moody's Corp. ( MCO - Analyst Report ) has a negative outlook on the U.S. at present.