3 Implications Of A Fiscal Cliff Tax Hike

Includes: DVY, HDV
by: Russ Koesterich, CFA

From the outside, it’s hard to find much evidence that Washington is getting closer to a fiscal cliff deal. Perhaps there is more going on behind the scenes than the headlines suggest, but as of today it is hard to find much evidence that the odds of a deal have risen. As the potential for fiscal drag rises, it is worth reiterating why this is so dangerous. From my perspective, the biggest risk to the economy, and to financial markets, comes from the tax side of the equation.

To review, the fiscal cliff comprises a series of tax hikes, including: marginal tax rates, payroll taxes, capital gains, taxes on dividends, estate taxes, and a new 3.8% tax on non-wage income for high earners. In addition, without legislative action, the alternative minimum tax (AMT) will hit millions of more Americans. In aggregate, the combination of these tax increases and new taxes will equal roughly $400bn.

While the $400bn figure is normally compared to overall gross domestic product (GDP), a more relevant comparison is against disposable income, which will take a direct hit as a result of these tax increases. US Disposable Income is currently a bit below $12 trillion, which means the tax increases, should they last the full year, represent roughly 3.5% of what Americans take home on an annual basis. As I’ve argued in past, this is a very large tax hike.

Also, it will be happening at a time when income growth is already very slow. As of October, disposable income was growing at around 3.5% year-over-year, half the 50-year average. For hourly workers, the situation is even worse. Hourly wages are growing at little better than a 1% year-over-year pace. The tax hikes, particularly the jump in the payroll tax, will hit hourly workers hard.

Should these tax hikes hit, and remain in place, there could be several implications:

  1. Potential recession. Most importantly, a tax hike of this magnitude set against a weak expansion will probably lead to another recession as consumers are forced to pull back on spending.
  2. Unusual trading. Next, we are likely to see a continuation of a very unusual end-of-year tax trading – namely, investors selling winners to minimize capital gains liabilities.
  3. US market underperformance. Finally, we expect to see international markets outperform the United States. Since peaking in September, the S&P 500 is down roughly 4%. In comparison, the MSCI? ACWI-ex US Index is within a few points of its September high.

One thing we don’t expect to happen – a massive sell-off in dividend stocks. We have maintained for some time that with the exception of U.S. utility stocks, we don’t believe the dividend space is more vulnerable than the broader market. Since the September high, the two US iShares dividend funds, the iShares High Dividend Equity Fund (NYSEARCA:HDV) and the iShares Dow Jones Select Dividend Index Fund (NYSEARCA:DVY), are performing in-line with or better than the S&P 500.

While Washington is, at least in theory, capable of compromise, time is running short. While a plunge over the fiscal cliff can be rectified in 2013, investors are justified in being cautious. Until we see the parties move off of their entrenched positions, we’d embrace three strategies: stay defensive, don’t abandon dividend stocks and favor international equities.

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