Economic News & Analysis—January 2, 2013

Fiscal cliff: A 13th-hour deal

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

After a nail-biting, hair-pulling, and sometimes otherwise annoying New Year’s Day, the House of Representatives finally passed the same measure as the Senate. The process and the result prove that Otto von Bismarck, the first chancellor of Germany, was right when he said, “Politics is the art of the possible.” It certainly is not the science of the perfect.

There were some positive elements to the deal. Some of the tax policy of the past 11 years was made permanent. Also, the alternative minimum tax (AMT) exemption and the estate tax exemption were indexed to inflation, so they won’t need to be periodically fixed. Here’s a snapshot of what the deal achieves:

Political:

  • The automatic spending cuts scheduled to begin (the sequester) were postponed for two months. As a result, we’ll see more political theater around that time.
  • The debt ceiling wasn’t part of the deal, which is important because it will likely need to be raised in February or possibly in March. Republicans may be looking to that debate as an opportunity to move entitlement reform forward and address concerns about the sequester.

Taxes:

  • Payroll taxes are increasing. For 2011 and 2012, employees received a two-percentage-point reduction in payroll taxes. Payroll tax rates will now revert to their pre-2011 levels, which could mean approximately $120 billion less in take-home pay for all Americans. When the payroll tax cut first went into effect, the extra take-home pay seemed to help people reduce debt, increase savings, or purchase durable goods (items lasting three years or longer, such as cars and washing machines). A payroll tax increase will likely have the opposite effect.
  • Income taxes will remain the same for most Americans, and those rates are now permanent. Not only are income tax rates rising to 39.6% for individuals earning more than $400,000 a year ($450,000 for married couples), exemptions and deductions are being limited for individuals earning more than $250,000 a year ($300,000 for married couples). There is also the additional health insurance tax of 0.9% on individuals earning more than $250,000, which was part of the Affordable Care Act. In all, the economic drag from this tax increase will be less than what it would have been if the income threshold was set at $250,000, so I guess that’s a positive.
  • The capital gains tax rate and qualified dividend tax rate for people earning more than $400,000 will increase from 15% to 20%. There is also the additional 3.8% health insurance tax on investment income applicable to everyone making more than $250,000—another part of the Affordable Care Act—so the actual tax rate is 23.8%. At least the qualified dividend tax rate wasn’t increased to the same level as the income tax rate. Taxing capital gains and dividends at different rates creates an incentive for businesses to favor share buybacks over paying dividends, which isn’t always in shareholders’ best interests.
  • The AMT was fixed so it won’t capture millions more people in its clutches. It was also indexed for inflation so Congress will no longer need to adjust it annually.
  • The expanded earned income tax credit, child tax credit, and college tax credit that were part of the 2009 stimulus were extended for five years.
  • Many business tax breaks were also extended (for example, research tax credits). I found it encouraging that companies will get 50% bonus depreciation for 2013. In 2011, businesses could fully expense investment in capital equipment, which encouraged investment by lowering tax bills. In 2012, that was cut to 50%.
  • The estate tax exemption level was kept at $5 million, but the tax rate was increased from 35% to 40%. The exemption amount was indexed to inflation.

Government payments:

  • Expanded unemployment benefits were extended for one year.
  • Doctors accepting Medicare patients will not see their reimbursements cut by nearly 27% in 2013.
  • The 1949 milk price support program that threatened to nearly double the price of milk was defused by giving the farm bill a nine-month extension.
  • Congress and federal civilian employees won’t get a cost of living pay raise in 2013.

My back-of-the-envelope calculation says this will create approximately a $180 billion drag on the economy, which is significantly better than what it could have been. I believe the deal will favor dividend-paying stocks and multinational businesses focused on developing and selling equipment and software to other businesses but perhaps hurt some consumer-facing durable goods companies, which will be adversely affected by the payroll tax cut expiration.

Over the next three months, we’ll have at least three more opportunities to watch the thrilling back-and-forth and brinkmanship: The sequester postponement will expire in two months; the debt ceiling will need to be raised before the end of March; and the continuing resolution that has been funding the federal government because a budget hasn’t been passed in four years will expire in March. In terms of the political environment, Washington, D.C., sent a clear message to America: Happy new year…nothing’s really changed!

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