The Fiscal Cliff: A 'Taxing' Predicament

by: Matt Erickson

For the past several months, all of the talk in the financial markets has focused on what has been going on over in Europe and how this might impact the global markets. But lately, more and more we have begun hearing about the upcoming "fiscal cliff" we face here in the United States. But what is the fiscal cliff and how might this impact us?

The purpose of this commentary is to provide timely insight into what is going on in the financial markets, so that one may gain deeper understanding of some of the challenges at hand. Certainly, the fiscal cliff provides us with a topic of great debate and most assuredly one that will be a focal point as we near the upcoming elections. In this debate and in the context of this commentary we do not aim to take sides, rather to provide a framework for understanding our current situation.

We begin by taking a closer look at our current tax code, what many of us know today as the Bush-era tax cuts. We'll do our best to put this into historical perspective then delve into what it may mean for our economy if these tax cuts are allowed to expire.

The Economy B.O.

Before Obama took office, for eight years the land of the free was presided over by President George Bush Jr. Similar to President Barack Obama, George Bush entered the oval office at a time in which the economy was sputtering. After a decade in which we witnessed the strongest returns in the history of US capital markets (where stocks posted greater than a 17% average annual return), the excesses and mass consumption had begun to unwind. With the bursting of the "tech bubble" in the United States, domestic equity markets lost nearly 50% of their value in the first three years of the Bush Administration. Many investors lost far more, placing outsized bets on technology companies.

As if our economic frailties were not enough, lest we forget President Bush also faced the great misfortune of presiding over this nation during the catastrophic events of 9/11. The economy was in a tailspin. While this period may have been best reflected as a time in US history in which all Americans felt a tremendous kinship - coming together, united at a time of crisis - the prevailing emotion in the equity markets was that of fear and an utter lack of confidence.

In an attempt to stoke the economy, President Bush presented congress with what we know today as the Bush-era tax cuts. At a time of despair, Bush's actions were intended to place more money into the pockets of would be consumers. In a nation where historically 70% of GDP has been attributed to consumer spending, we acted as one might expect. With more money in your pocket, the proclivity is to spend it, and ultimately we did; accordingly the US made its way out of recession.

The "Bush Tax Cuts" were enacted in two stages: 1. The 2001 Economic Growth and Tax Relief Reconciliation Act of 2001 ((EGTRRA)), and 2. The Jobs and Growth Tax Relief Reconciliation Act of 2003 ((JGTRRA)).

2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA)

Notable provisions included:

  • Cut income tax rates: created a 10% tax bracket, the 15% tax bracket was lowered to 10%, the 28% bracket to 25%, the 31% bracket to 28%, 36% bracket to 33%, and the 39.5% bracket to 35%. Increased the standard deduction for married couples
  • Increased the child tax credit and amount eligible for credit spent on dependent care
  • Increased contribution caps for a variety of savings programs (401k, IRA, etc.)
  • Created "catch-up" provisions in qualified retirement plans, enabling workers over the age of 50 to make increased contributions
  • Increased the exemption for the Alternative Minimum Tax
  • Created a new depreciation deduction for qualified property owners
  • Reduced the capital gains tax
  • Gradually increased the estate tax unified credit exclusion from $675,000 in 2001 to $3,500,000 in 2009.
  • Reduced the maximum estate tax from 55% in 2001 to as low as 45% in 2009

2003 Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)

Notable provisions:

  • Accelerated the timeline for tax cuts created under EGTRRA
  • Cut taxes on dividends and capital gains
  • Increased the income thresholds for each respective tax bracket

Over the next several years, the US economy seemed to right the proverbial ship. But percolating beneath the apparent calm waters was a threat that could potentially send the whole world into a mass depression; far worse than previous generations here in the United States endured. With the entire financial structure of the global economy teetering on the precipice of destruction, President Barack Obama began his tenure as President of the United States.

The Economy A.O.

After Obama took office, a tsunami of events took place that shook the foundation of the global economy. What began as a crisis in mortgage backed securities, morphed into government bailouts and ownership stakes in public companies (banks, automobile manufacturers, insurers, etc.). In the end, in order to stave off a global depression, central banks from around the world have taken part in coordinated quantitative easing efforts; essentially printing more money / issuing more debt, lowering benchmark interest rates, and establishing themselves as primary buyers of last resort. All of these measures have been taken in an effort to stimulate a slowing global economy, one that as of late has again begun to sputter. But recently, many have begun to question what more central bankers can really do? Interest rates are already at or near zero.

This has created a conundrum for both lawmakers charged with the responsibility of managing and drafting fiscal policy, and central bankers navigating monetary policy. It has not been an easy road and certainly each party has taken their turn trying to point their finger at the other, as they struggle to come up with answers (many of which remain unpopular by the masses).

In the US, we have witnessed an economy traditionally based on consumer spending for growth, transition to being propped up by government spending. Yet, we all know this can't go on forever. With government balance sheets bulging out of control, at some point in time they are going to have to step back. In which case, the torch will again be passed to the consumer to provide sustainable economic growth. The question is whether the consumer will be ready.

With all that has transpired in recent years, the consumer in the US has suffered substantial losses and often incurred significant debts. Many have lost as much as 50% or more on their homes, and perhaps just as much in their investable assets. At the same time, unemployment remains untenably high, wage growth is anemic, and many consumers continue to face payments on a mountain of debt accumulated during better times (when we all thought things could only go up in value - our investments, homes, incomes, etc.). In effect, the US consumer is attempting to deleverage their personal balance sheets while governments are massively and unsustainably increasing theirs. Not such an easy task given the circumstances we find ourselves in.

Elected officials around the world must strike a delicate balance between providing a means to slow down government spending and increase income (taxes levied), without choking off the consumer entirely. Obviously, this is not an enviable task. But as our global leaders grapple with how to solve our long term problems, in the short run they are working to prevent another recession. During the average recession, equity markets historically lose more than 40% of their value. To this point, we have not even gotten back to the highs the US markets achieved in October of 2007. A 40% drop from here would be devastating.

A Taxing Predicament

So here we are, it's an election year and with both parties maintaining such polar opposite positions regarding the fiscal cliff et. al, any chance for bipartisan diplomacy is slim at best. But if nothing is done by year end, the Bush-era tax cuts will expire, and the ripple effects will be felt far and wide.

A number of individuals and entities have recently begun to forewarn us about what may lie ahead:

  • The Congressional Budget Office has publicly stated that if Congress does nothing to soften the blow of higher taxes and lower spending, the changes would devastate the economy and provoke a recession in 2013.
  • Former President Bill Clinton has echoed these statements further, suggesting that tax cuts for people of all incomes, including the rich, should be extended into 2013 to avoid economic harm and allow time for a broader fiscal deal.
  • In recent testimony before Congress, Federal Reserve Chairman Ben Bernanke implored lawmakers to take action to address the fiscal cliff, citing that such a "severe" tightening of fiscal policy would "pose a significant threat to the recovery" if it were allowed to proceed. He has also indicated that the Fed would be hard pressed to offset the full effects of such moves.
  • The IMF (International Monetary Fund), in its annual review of the US economy warned, "Failure to reach an agreement on near-term tax and spending policies would trigger a severe fiscal tightening… with negative growth early next year and significant negative repercussions on an already fragile world economy."

While many may look at this as a potential story for 2013, the impact will be felt far sooner. Facing what some have estimated to be more than $600 - $700 billion in higher taxes and spending cuts, US companies are already pulling back. Many have already begun to delay hiring and spending, anticipating the impact of pulling hundreds of billions of dollars of purchasing power out of the economy. As cited by Michael Hanson, senior U.S. economist at Bank of America, "You don't board up the windows when the hurricane is there, you board up the windows in anticipation."

High net worth investors may soon begin to batten down the hatches as well. With the potential increase in tax rates, many investors holding substantial long term gains may seek to recognize them in 2012 - at what may be substantially lower tax rates than what we are likely to have for the foreseeable future. Pushing profit taking by wealthy investors into 2012 may very well create further selling pressure in the investment markets.

Beyond the economic landscape and potential impact on the investment markets, how will the upcoming fiscal cliff impact how much we pay in taxes? According to the Tax Policy Center (a non-partisan research group in Washington), if Congress does nothing, households of all income levels would see their taxes go up: low income earners would see their income tax increase from the current level of 1% up to 5%, middle income from 14% to 18%, and high income earners from 31% to 38%. The average tax increase per household would be $3500.00. (Click on the link above to view an excellent video clip illustrating through these changes.)

I think we can all see where this is going... If lawmakers do nothing, by all accounts we are likely to see a recession. Should lawmakers extend the Bush-era tax cuts, you make no progress towards long term deficit reduction, potentially raising the risk and magnitude of a future financial crisis.

Over the past few years, policy leaders worldwide have grown accustomed to kicking the can down the road with each step in this ongoing financial crisis (making incremental moves rather than cultivating viable long term solutions). More recent attempts seem to have evolved into simply just trying to kick the can out of the driveway. And now we fear there may not be enough firepower left to simply kick the can over.

So what does the mean for the remainder of this year and into 2013? No one can say for sure, but the challenges are formidable, and we all know that US companies as well as the investment markets despise uncertainty. As such, we are currently faced with significant headwinds. At times like this, rather than engage in a herculean bout of finger pointing, it would be nice to see political leaders come together on a bi-partisan, workable solution. For now, the discord appears too great. And in an election year where these guys and gals are trying to get re-elected, it seems to be protocol to try to win by discrediting your opponent, rather than on the virtues of what you bring to the table to solve the problem.

Investing in An Uncertain World

So here we are... Bonds are the most expensive they have ever been, stocks are up more than 100% in little more than 3 years, global growth is slowing, and geopolitical risks are on the rise. Where is an investor supposed to place their hard earned savings for long term growth and preservation of capital?

This is where the investment landscape has changed. What was previously impossible, is now possible. ETFs provide investors with liquidity, transparency, low cost, and broad diversification. The construct of a portfolio can be dramatically changed with only a handful of trades. This provides investors with the opportunity to implement tactical allocation shifts that can be utilized to side step prolonged declines in the investment markets; protecting the portfolio from incurring a permanent impairment of capital.

According to Morningstar, "Exchanged Traded Funds (ETFs) continue to command more incremental investment dollars from advisors and investors. For the one-year ended Dec. 31, 2011 Morningstar estimates that net inflows to ETFs were $121 billion compared with $56 billion for open-end mutual funds." Within the ETF segment of the market, the most rapidly growth category is in Managed ETF Portfolios, with an estimated growth for the year ending Dec. 31, 2011 of 43% year over year.

The greater investment community continues to hold onto age old investment practices that over time have proven to be highly fallible, and certainly have done little to shield investors from experiencing significant losses. But the reality is that the investment vehicles available today enable investors to employ strategies that previous generations did not have access to. Rather than "asset allocation," a prudent investor today should consider "asset rotation."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.