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Have We Avoided the Fiscal Cliff?

 

A last-minute deal to avoid the fiscal cliff passed both houses of Congress on January 1, 2013. While the extension of the “Bush Tax Cuts” was widely anticipated for low and middle income wage earners, the delay of spending cuts is a cause for concern. Equally concerning are the reversion of the FICA tax rate and new Medicare taxes, and their impact on fragile consumer spending. Given a series of events that must occur over the next two months, it will be more time before we know if we have truly avoided the fiscal cliff.

At the 12th hour, the Senate and the U.S. House of Representatives passed legislation that removes the temporary end date and makes permanent the income tax rates enacted in 2001 and 2003 (the “Bush tax cuts”) for all wage-earners under $400,000 ($450,000 for joint filers). As we noted in our previous article, “The Impending U.S. Fiscal Cliff”, October 31, 2012, this move was generally anticipated. Financial markets also had time to adjust to the end of the “cuts” for high-income wage earners, especially following the outcome of the presidential election. Removing this tax component of the fiscal cliff also removes a potential 1.0-1.5% drag on economic growth, and prevents the economy from going over the “Cliff”. The fact that spending and sequestration cuts have been put on the back burner for two months did not seem to bother financial markets, which had given up hope for a “grand bargain” over the last couple of weeks. While financial analysts point to the long-term economic ramifications if spending on entitlement programs and additional tax reforms are not addressed seriously during the next round of negotiations, for the time being the financial markets seem content that a level of uncertainty has been lifted. Most are hoping the economy can get back on track especially given improvements in the housing sectors.

However, my concern is the lack of focus yesterday on the fact that most wage earners will see a 2% increase in their FICA tax, removing real money from the pockets of consumers, who have most likely adapted to the lower FICA rate. This could translate into a 0.6% drag on GDP in 2013. On top of that, those with income over $200,000 ($250,000 for joint filers) will see a new 3.8% Medicare tax applied to the lesser of modified adjusted gross income or net investment income, which was mandated by the Affordable Care Act. While consumer confidence posted a new, post-recession high in November, it was on the back of improvement in housing, while the continued lack of jobs and income growth were still of concern to consumers. In December, the indicator fell dramatically, with consumers expressing concern that economic prospects looked bleak. Given the still-fragile confidence level, these additional taxes could potentially stop consumers in their tracks. Weakness is already showing up in some indicators for retail, service and non-durable spending. These issues have not been completely lost on some analysts who have revised estimates for 1st quarter 2013 GDP lower in the last 24 hours, (even to levels between 0.0-1.0%), although they still believe housing and pent-up auto demand will keep the U.S. out of recession in 2013.

It should be noted that countering some of this income impact will be the one year extension of unemployment benefits for those unemployed more than 26 weeks. This extension does add about $30 billion to the deficit.
It also appears as though the markets are ignoring the political discord, on display since the debt ceiling debates in 2011, which has continued to produce less-than-satisfactory debt-reduction results for the ratings agencies. Once again, the ratings agencies are sending strong signals that it is this component of the deal that is most worrisome with regards to long-term U.S. financial stability. Moody’s warning yesterday served as a reminder that if additional significant deficit-reductions do not materialize, their AAA U.S. credit rating is in jeopardy. This follows warnings by both Moody’s and Fitch to legislators, most recently in September, following the issuance of a negative outlook being placed on their ratings.

Other key components of the legislation were:

For income below $400,000, tax rates on capital gains and dividends will stay at 15%, but increase to 20% for income earners over $400,000.

  • Estate taxes rise from 35% to 40% with an exemption of $5 million.
  • Tax deferred 401(K) participants can now convert to a Roth 401(K) account without incurring an early-withdrawal penalty, if their employer offers this option. This was included by Congress in the hopes of potentially raising about $12 billion in additional tax revenue over the next ten years, as defined contribution participants pay income tax on the conversion.
  • Clarification to the Alternative Minimum Tax (AMT) legislation.
  • Other tax credits for businesses for research and development expenses, and tax credits for low income wage earners.

In the coming weeks, Congress will take up the debt-ceiling debate once again, and will need to address mandated spending cuts that were deferred until March 1. Expect these discussions to encompass entitlement and tax reform. The outcome remains to be seen, and until then, investors will most likely experience the same “risk-on, risk-off” environment as in 2012.