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By Jason Born, CFA

We hope to shed light on the looming "Fiscal Cliff" by defining what happens upon its commencement and what the short-term and long-term effects may be.

WHAT IS IT?

The "Fiscal Cliff" is political slang for the self-inflicted changes that go into effect on 1/1/2013. These changes are indeed self-imposed because they are the direct result of Congressional, Senate, and Presidential action or inaction as the case may be. As the laws stand today, a host of changes will occur to tax rates and spending. It is clear that nothing will occur between now and the November election, so it will be left to the lame-duck legislative branch to halt progress toward or adjust the height of the cliff. A summary of the changes is as follows:

Tax Increases

  • End of the temporary payroll tax cut (2% tax rate increase for workers)
  • Marginal income tax rates increase (10% bracket goes to 15%, 25% bracket goes to 28%, and 35% bracket goes to 39.6%)
  • Reduction of child tax credit from $1,000/child to $500/child
  • Return of the "marriage penalty"
  • Long-term capital gains tax increase (from 15% to 20%)
  • Dividend tax increase (from 15% to ordinary income - i.e. 15%, 28%, or 39.6%)
  • Increase in estate tax rates and decrease in exemptions
  • Alternative Minimum Tax will immediately effect more households
  • Business tax provisions (i.e. research incentives, biodiesel incentives, etc.)
  • Affordable Care Act (Obamacare) taxes begin (0.9% surtax on salary income over $200k, 3.8% surtax on investment income, including capital gains and dividends, for individuals earning over $200k)

Spending Cuts

  • Medicare spending cuts
  • Defense discretionary spending cuts
  • Other non-defense discretionary spending cuts

SHORT-TERM IMPLICATIONS

It is a near certainty that should the "Fiscal Cliff" come about in full, economic growth will slow in 2013. Or, as the Congressional Budget Office estimates, we may experience a recession. Such a situation is unavoidable as taxes will immediately increase by about $400 billion, while spending will immediately fall by about $200 billion for a nearly $600 billion swing. This amounts to 3.5% of the annual output by the U.S. as measured by the GDP.

Should a recession occur, prices of risk assets such as stocks, commodities, real estate, or high yield bonds will likely drop. Remember these sale prices may provide opportunity for long-term investors. Bonds of high credit quality should fare well, on the other hand.

LONG-TERM IMPLICATIONS

While we would certainly prefer elected officials to govern, these automatic spending cuts may result in more restraint of government spending over time. This leads to less borrowing and perhaps a more fiscally responsible government - good things all around. Over time the U.S. may even find it earns back the trust of ratings agencies and is found to have a AAA rating again, aiding in keeping borrowing costs low.

The tax increases are not ideal, and may snip the ability of the economy to grow at its maximum potential over coming business cycles. However, with the exceptions of the vast unknowns with regard to the Affordable Care Act taxes, we have survived quite well under the tax rates we will have in 2013.

Given the forced spending cuts in the "Fiscal Cliff," we deem its long-term effects as a positive for our nation's economy. Tax rates can, do, and will change again. So whatever side of the argument you find yourself, wait a year and they'll change again. However, it is that pesky spending that is so hard to cut. On 1/1/2013 we will finally get at least a less-than-perfect set of spending cuts.

Source: Fiscal Cliff And Its Implications