Wednesday, August 26, 2009

Implications of the Deficit

The Office of Management and Budget revised its May deficit projections to forecast a record $1.6 trillion deficit for the fiscal year ending September 30. Worse, the White House forecast $9 trillion in additional debt over the next decade. Amazingly, borrowing alone will account for 40% of federal revenues in 2010!

Over the short term, a majority of the deficit surge stems from temporary outlays. Of the $700 billion increase in spending that is forecast for 2009, $424 billion comes from the Troubled Asset Relief Program (TARP) and the rescue of Fannie Mae and Freddie Mac. An additional $115 billion comes from President Obama's stimulus plan. Unfortunately, beyond 2010, deficits will remain high largely because of spending on Medicare, Medicaid, and Social Security. These costs aren't tied to recession; they simply rise as baby boomers age.

A higher federal deficit would cause several hurdles as the U.S. tries to dig itself out of the recession. First, the Federal Reserve recently communicated that the U.S. must show progress on deficit reduction by next year to avoid the possibility of a rise in interest rates, which might be needed otherwise to entice global investors to keep buying U.S. government bonds. Higher interest rates slow economic growth, and would raise the U.S. government's borrowing costs.

Large federal deficits could also weaken the U.S. dollar against foreign currencies. That could fuel inflation as the cost of imports rises in dollar terms. Of course, high inflation would reduce purchasing power, putting a squeeze on American consumers.

Finally, how is the federal government going to reduce this deficit? Simply, there are two potential solutions: reduce spending, or raise revenues. We've already identified several financial obligations that are not likely to be eliminated anytime soon, so let's examine the possibility of raising revenues. What is the easiest source of new revenues? Tax dollars. In fact, budget experts are increasingly reiterating their belief that tax increases may need to hit families that the president vowed to protect --family earning below $250,000. Consequently, it is a very real possibility that tax rates will be increased across the board.

Now would be an ideal time to visit a financial advisor to prepare your portfolio for uncertain tax implications. Roth accounts and alternative investments are a couple of investment options that can provide "tax diversification" to your portfolio. However, to protect yourself from salesmen posing as "financial advisors," be sure to speak to an independent, fee-only financial planner to ensure your best interests are the priority.

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