EmailThere is a much greater risk to the financial markets from the so-called “fiscal cliff” than is in current prices. A cliff is unlikely. There is likely to be a compromise. That means there could be significant tax increases. This isn’t a reprise of the debt ceiling crisis of last year where everything worked out just fine.
The Fiscal Cliff List
The following is a list of the major issues that will take effect January 1, 2013, if Congress does not act.
Spending Cuts:
- A $55 billion defense spending cut from current projections. 2) A $55 billion cut in discretionary spending from projected levels.
- Dividend taxes jump from 15% to a filer’s income tax rate (as high as 39.3%).
- Long-term capital gains rate goes from 15% to 20%.
- Employee contribution to Social Security goes back to 6.2% on the first $110,100 in wages, up from 4.2%.
Other tax increases:
- Child tax credit lowered from $1000 to $500, correction for marriage tax penalty expires, reduced levels of deductions for high-income filers.
- Top estate tax rate rises to 55% from 35% and the exempt level drops to $1 million from $5 million.
- The level at which the alternative minimum tax (AMT) applies drops significantly, forcing more tax filers to pay the AMT.
This isn’t even close to a comprehensive list. There are also a lot of targeted tax breaks and deductions from recent years for small businesses and for individuals that are small compared to the list above.
There are two other issues which must be noted, however, as they have significant political impact.
- Unemployment benefits will be for only 26 weeks rather than the recently extended levels of up to 99 weeks.
- Doctor payments for Medicare patients will plunge 27%.
Finally, there is also a 0.9% Medicare surtax on high-income earnings and 3.8% surtax on capital gains and dividends that will go into effect as part of the Affordable Care Act. These won’t even be subject to debate or change. They are going to happen.
Economic Impact
It is quite a list. The total amounts to huge tax increases and spending cuts that will sharply curtail economic activity.
The Congressional Budget Office states that implantation of these changes would throw the economy into recession, and almost all economists agree. The economy would drop off a cliff because of these changes to fiscal policy – hence, the “fiscal cliff.”
The simple math is that the Keynesian impact of these changes would have an immediate negative impact on the economy. No one wants that to happen.
It is also axiomatic that increasing taxes on something reduces its value and produces less of it. If dividends and capital gains taxes go up, the value of stocks goes down. The mathematical impact of higher taxes on stocks is debatable, but the direction is not.
The Difference from the Debt Ceiling Risk
The financial markets are taking a nonchalant attitude towards the potential problem based on the fact that almost everyone, including leading politicians of both parties, agrees that going off the fiscal cliff would be a disaster.
The thinking seems to be that, because there was a serious risk of a fiscal disaster last year with the debt ceiling, and politicians ultimately did the right thing and raised the ceiling, that a repeat of a last-minute solution will happen.
That is an extremely risky conclusion. The fiscal cliff problem is much different than the debt ceiling problem last year for several reasons.
First, there was a clear, simple, correct answer to the debt ceiling problem. Raising the debt ceiling was essentially procedural and had been done many times previously. Congress finally got around to doing that after some politics. There is no clear, correct answer to the fiscal cliff issues.
Second, raising the debt ceiling was a single issue. The fiscal cliff issues are multiple, and involve multiple pieces of legislation. That greatly complicates the matter.
Partisan Disagreements
Consider, for example, the differences of political beliefs on the income tax rates. Many Democrats, including President Obama, have argued in favor of allowing at least the top tax rates to increase under the belief that is in the best interests of the economy and the country. Republicans disagree. Readers of this article probably disagree.
The point is that this is not an issue for which there is a clear, correct answer, as with the debt ceiling.
Nor is it the only critical issue. The debate over raising the top rate will impact the debate over capital gains and dividends as well. There might be trade-offs discussed in attempting a political compromise. Of the 535 members of Congress, there will be vast disagreements as to the appropriate policies. Reaching any kind of conclusion, even one that includes “kicking the can down the road” won’t be easy.
It is simply wrong for stock market participants to assume the Congress will “do the right thing” and take action to prevent any disruption to the stock market. To many politicians, the so-called Bush tax cuts are anathema. Just because portfolio managers want the cuts retained doesn’t mean that is what a political compromise will include.
Timing of the Political Debate
There is no chance that these issues will be addressed prior to the November 6 election.
The market assumption seems to be that the fiscal cliff issues will be addressed in a lame-duck Congress after the elections. That is a huge leap of faith.
It is not at all clear that President Obama would sign legislation extending the Bush tax cuts, whether he wins re-election or not.
It is at least possible that the elimination of the pressure from the election allows the leaders of both parties to reach a compromise. But that would likely entail tax increases on income, dividends, or capital gains that are not now priced into the stock market.
There is also a very good chance that January 1, 2013, comes with no resolution whatsoever.
Election Results
Current election odds from Intrade.com suggest that there is about a 43% chance of a Romney victory. There is about a 20% probability of a Romney win coupled with a Republican sweep of Congress.
There is only a 4% chance of a Democrat sweep (because the House is highly likely to remain Republican).
There is thus about a 75% chance of divided government following the election.
If the Republicans do sweep, then the stock market may well get what is currently assumed – no tax increases and no immediate spending increases.
There is a much greater probability, however, that a split government will have to come to a compromise.
It is certainly a guess what a compromise would entail, but it almost definitely won’t include everything the financial markets desire.
Taxes will go up. And it is most likely that tax increases will impact high-end earnings, dividends, and capital gains.
What It All Means
There is a huge risk that the stock market is underestimating the impact of impending fiscal changes.
A full fiscal cliff is unlikely, but selected higher taxes that might be better termed a “fiscal slope” are likely.
The blithe assumption that a lame-duck Congress will attempt to give the financial markets everything good for stocks is absurd. Politicians are just as likely to dig in their heels on their political beliefs as to compromise once the elections are over and their positions are more secure.
Fiscal issues and risks will become far more prominent once the situation with regard to another potential round of quantitative easing becomes clear.
The belief that politicians will ultimately do “what is right for the country” and that fiscal issues will be resolved to the satisfaction of stock market participants simply because that is how the debt ceiling crisis ended... is simplistic and risky.
Founder and Chairman, Briefing.com
