A Headwind For The U.S. Economy: Tax Uncertainty

by: Russ Koesterich, CFA

When contemplating investment decisions, it’s generally a good idea to consider the future tax implications of any moves you might make. Unfortunately, this is especially difficult to do today.

The future of the US tax code has never been more uncertain, harder to plan for and such a looming potential headwind hanging over the US market.

Thanks at least in part to Congressional efforts to lower the official impact of tax cuts a growing percentage of the code is now comprised of temporary tax breaks and provisions.

Take the year 2013 when numerous tax policies are set to expire including the 2% payroll tax holiday and current rates of estate taxes. Also in 2013, the Bush tax cuts, which impact marginal tax rates, capital gains taxes and dividend taxes, are scheduled to expire. On top of all that, additional taxes are set to be imposed in 2013 such as a new 3.8% tax on unearned income.

Whether these hundreds of billions of dollars in tax hikes actually occur, however, will depend in part on the outcome of the November elections.

In the event of a Republican sweep of both Congress and the White House, most, if not all, of the tax hikes mentioned above will probably be avoided and marginal tax rates could be cut. On the other hand, if a Democratic sweep occurs, tax hikes on middle income individuals will likely be avoided, but tax hikes for upper-income individuals will probably occur. Under such an outcome, new provisions could also make the tax code even more progressive.

However, if the government remains divided after the elections, which I believe is most likely, all bets are off and the tax outlook is particularly hard to predict.

What does this mean for investors? Since the near-term future of tax policy is still so uncertain and impacts all asset classes, there’s no action I would suggest investors consider taking today. But later this summer, as the elections draw nearer, investors should pay close attention to the outlook for taxes.

If 2013 tax hikes seem set to hit on schedule, I would be more bearish on the US economy and US equities. In such a scenario, the US economy would likely face $500 billion to $600 billion in fiscal drag — a significant damper on economic growth and consumption from higher taxes.

And lingering uncertainty over taxes into 2013 would also be a negative for the US economy because of the potential harm it could cause to US confidence and business spending.

Source: Bloomberg

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