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Friday, January 11, 2013

Our Perspective on the Fiscal Cliff Deal

In the wee hours of New Years day, lawmakers passed a bill to “avert the fiscal cliff”.  The following details important items of the bill agreed upon by Congress as well as our analysis of the legislation.
 
Payroll Tax: The payroll tax holiday of the last two years is over.  That means that wages up to $113,700 will be subject to a payroll tax of 6.2% rather than the 4.2% at which they have been taxed over the last two years.  For the median household income of $50,000 that is a tax increase of $1,000/year while for those earning the maximum level that is taxed, $113,700, that will mean an extra $2,274 in taxes this year.
Top Tax Bracket: Technically moves from 35% back to the Clinton era rate of 39.6% for individuals earning more than $400,000 annually and couples earning more than $450,000 annually.  Additionally, the bill reverts to itemized deduction limits imposed during the Clinton era on individuals earning $250,000 or more and couples earning $300,000 or more.
Capital Gains Rate: Raised to 20% for top income bracket, but there is a surtax for the healthcare reform of 3.8%.As such, long-term capital gains and dividends for the top brackets will be taxed at 23.8% while they will remain taxed at 15% for all others.
AMT (Alternative Minimum Tax): Probably one of the most intelligent measures in the bill, Congress finally agreed to a permanent inflation patch on the AMT so that it does not need to constantly be adjusted to prevent those of relatively modest means falling into the AMT.
Business Tax Credits: Extended the 50% bonus depreciation that was to expire in 2012 through 2013 (part of a deal that had allowed total expensing in 2011, 50% depreciation in 2012, and was then to revert to normal depreciation schedules in 2013).  This may lead to slightly more business investment, or “cap-ex” spending, this year than we might have seen otherwise.  On the other hand, businesses looking to take advantage of this prior to its original expiration in 2012 likely pulled forward some cap-ex spending into 2011 and 2012, so the benefit is likely to be limited.
Medicare Reimbursements Rate: Extended current payment rates through 2013, delaying until next year what were to be significant cuts in reimbursement rates.
Summary: Bloomberg cites the Tax Policy Institute in stating that the reversion of the payroll tax to its ordinary level will pull $100 billion out of the US economy this year.CBS News cites the CBO as stating that the deficit will be $3.9 trillion larger over the next decade relative to what it would have been had the Bush tax cuts been allowed to sunset.  The bill pushes sequestration back to March 1st, meaning Congress and the White House now have two months to address what they have failed to address over the last 16 months.  Additionally, the debt ceiling limit was hit on Monday and Treasury Secretary Geithner has taken steps to avert the debt level rising above the limit; a measure expected to buy 6-8 weeks.  The bill to avert the cliff does nothing to address spending and it is very likely that Republicans, having acquiesced to modest tax increases, will now demand significant spending cuts in the battle over the debt ceiling and sequestration.  Outside of patching the AMT, this bill was can-kicking at its finest.One could argue that making “permanent” the Bush tax cuts for 98-99% of Americans is part of the long-term solution.  We would disagree as revenue as a percentage of GDP is significantly below historical norms and is likely to remain there unless a larger portion of the population sees their income tax rates, or income, rise rather significantly.  And real income growth has been lagging in this economy since well before the recession.
The bottom line is that the bill has averted sending the US over the so-called fiscal cliff, a cliff that was of Washington’s own making.  It will impose modest fiscal contraction on the economy, but it does absolutely nothing to put US fiscal policy on a sustainable path.  At the same time, it settled absolutely nothing in Washington and one would have to believe that the new battles begin with the installation of the 113th Congress.  That Congress leaves Democrats with a modestly larger majority in the Senate and Republicans with a modestly smaller one in the House.
The market’s initial euphoric reaction over the legislation doesn’t surprise us, but neither does it make much sense.  At some point, we would expect market participants to awake to the reality that Washington has set in place another fiscal cliff, one that is only weeks away.  If they take hard measures to address long-term deficit reduction, it’s going to cut deeper into near-term economic growth.  If they do not, our debt and deficits will continue to spiral out of control.  Neither would seem to be great for near-term market prospects.