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The latest fiscal cliff follies are redolent of that old proverb:

For want of a nail the shoe was lost.

For want of a shoe the horse was lost.

For want of a horse the rider was lost.

For want of a rider the message was lost.

For want of a message the battle was lost.

For want of a battle the kingdom was lost.

And all for the want of a horseshoe nail.

On Wednesday, Treasury Secretary Geithner – one of the worst, if not the worst, Treasury Secretaries in history, I am pretty sure – said in an interview on CNBC that the Administration would “absolutely” send the country off the fiscal cliff if the rates on the top 2% of Americans don’t go up.

Now, I’ve heard lots of numbers bandied about, and decided I wanted to get the source data directly. The latest information I can find from the IRS is from tax year 2009, but it is instructive. According to the IRS, in 2009 there were 104,164,970 tax returns filed. The number with adjusted gross income above $200,000 was 3,912,980, or about 3.8% of all returns. They don’t break it down any more than that, so let’s call those successful people “the rich” and work from there.

Those 4 million returns covered $1.626 trillion in modified taxable income (32% of the total taxable income) and produced $429bln in tax (45% of the total tax generated). Now, let’s suppose that the top tax rate rose from 35% to 39.6% in tax, and for grins we’ll pretend that taxpayers are completely indifferent about this and so they do nothing to try and reduce taxable income (by, say, buying municipal bonds rather than corporate bonds). You might think that the tax take will rise by $74.8bln (4.6% * 1.626 trillion). But you’d be wrong, because the increase wouldn’t affect all of the taxable income paid by high-earners, but only that income that is taxed at the top marginal rate. In 2009, only $485bln in income was taxed at that rate, so a 4.6% increase in the marginal rate would only raise $22.3bln per year, or around $250-300bln over the next 10 years.

Now, over the last year the deficit has been about $1.1 trillion, so if I understand Geithner correctly, the Administration is willing to push the country over the cliff about an issue that amounts to 2% of the deficit, and would increase aggregate revenues by only 1%.

It’s one thing to argue for the philosophical point, but to say that you’re willing to put a hole in the bottom of the boat because you don’t like the seat you were offered…it seems a bit irrational.

What might be even more irrational is the sudden optimism that is breaking out all over Capitol Hill, about how great the economy will be if the fiscal cliff can just be averted. Thursday a Republican Senator being interviewed on CNBC said “The economy is ready to explode. There’s no doubt about that,” echoing what President Obama had said just a couple of days ago.

Do they mean implode, perhaps?

There is certainly no sign whatsoever that “the economy is ready to explode” ecstatically if the fiscal cliff is averted. Indeed, I think part of the reason we’re likely to go over the cliff is that the President wants to be able to blame the poor growth for the next few years on the Republicans in the same way he spent the last four years blaming the previous President. And the Republicans, since the Administration has offered no spending cuts and has dismissed entitlement reform altogether, don’t really have a choice unless they want to completely capitulate – at least with the fiscal cliff, some spending will be cut.

Since, if austerity is enforced, there will be no way to test the counterfactual, it makes sense to build up how great it would have been. But the point I want to make is that to proffer such a claim only makes tactical sense if no deal is in the offing…because if a deal is struck, then we’ll quickly find out that the economy isn’t going to explode higher at all, and those statements will be exposed as completely moronic.

We will on Friday find out how much the economy is not exploding – surely, because of the impending cliff – when Payrolls (Consensus: 85k vs 171k) and Unemployment (Consensus: 7.9%) are announced. These figures will be impacted by Hurricane Sandy, so it will be difficult to interpret them. Or, perhaps I should add cynically that this uncertainty will make it even easier for politicians to claim whatever the heck they want.

With 10-year yields already at four-month lows (1.59%) and the bullish seasonal pattern having run its course, I think the risk is for higher bond yields both Friday and going forward. Now, the 1.82% level has mostly contained any selloff since April, but I think we will be headed in that direction. Equities have downside risk in my view after this recent rally (an even more impressive rally when you consider that Apple (AAPL) was dragging on the index!); I think there is far too much optimism about an imminent resolution to the fiscal cliff, and I don’t think we’ll see any resolution until after the new year.

Source: For Want Of A Nail