Taxmageddon

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What to expect? No one knows for certain, but it is likely the cliff will NOT happen. Here are our thoughts.

Everyone now knows the outcome of the elections. With Obama winning a second term (by three percent of the popular vote), he now feels he has a mandate to tax the rich. He swept the battleground states and won the Electoral College handily. Democrats gained two seats in the Senate but the GOP held onto a comfortable majority in the House. What all this means, is more gridlock. But with the Fiscal Cliff looming, something has to give.

For most investors, the personalities and party in power does not matter; what matters is the direction fiscal and monetary policy will take. All eyes are on federal spending relative to GDP. This ratio peaked at a post-World War II high of 25.2% right after the 2008 recession and is still an unusually high 22.8% territory. Economists do not see this ratio falling under 20% anytime soon, which was where it was consistently during the pre Obama years.

Big government is not likely to push the economy into a higher gear. The “plow horse” economy remains the forecast for the next two years. But by all measures, equities are still undervalued, significantly.

For policy, the election means any chance of overriding Obamacare is done. The president’s health reform law will remain in place. High income earners now face a 3.8% tax on interest, dividends, and capital gains, as well as an additional 0.9% Medicare tax on regular income.

In terms of the “fiscal cliff” – we like “taxmageddon” better – let’s start with the easy stuff.

President Obama says he does not want military spending cuts to take effect and given how inclined some in the GOP are to the Pentagon, most of those budget cuts are not going to happen.

On taxes, everyone knows driving off the fiscal cliff would be economic suicide. Given the complexity of the issues and lack of time, it is probable an agreement to extend everything will be reached for one more year. This would give Congress and the president more time to work on something like Simpson-Bowles.

If this does not happen, then expect compromises as the cliff approaches. For example, rather than having the payroll tax rate rise by two points in 2013, perhaps it will be spread over two years.

As far as the Bush tax rates go, the thinking is Congress will keep the actual tax rates on income from going back up to where they were in 2000 and before. Both the President and Speaker Boehner have left the door open for making changes that do not lift the actual rates.

If the GOP offers to limit itemized deductions on high income earners by enough to raise the same amount of revenue that would be generated by lifting tax rates back to Clinton-era levels, a deal could be struck. Even the liberal Washington Post looks favorably on this idea and it would be much better for incentives and economic growth.

For capital gains and dividends, we expect the official rates to go from the current 15% to 20%. Adding the extra 3.8% tax from the health care law would put both rates at 23.8%. That’s higher than now, obviously, but the gains rate has hovered between 15% and 28% since the early 1980s and this new rate would be near the middle of the range, while the tax rate on dividends was 39.6% as recently as a decade ago.

Last but certainly not least, many now think the estate tax exemption will remain at $5 million and for the top tax rate to stay near the ultimate compromise for the top income tax rate.

In other words, while there is always a chance that America will fall off the fiscal cliff, but calmer heads are likely to prevail. In the end, the plow horse may stumble, but will continue to plod along.

 

This information is compiled by Guy Baker from an assortment of news feeds including First Trust, Yahoo Finance, Bloomburg and others. This information is intended to be informational only. This newsletter contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.