Dec. 31, 2012, looms ominously as the day of reckoning with regard to U.S. tax and spending policy. Dubbed the "fiscal cliff" by Fed Chairman Ben Bernanke, the end of the year marks the expiration of numerous tax rate reductions and the imposition of major across-the-board spending cuts. If no action is taken by Congress and the president, the American economy would sink back into recession by the second half of 2013, suffering a reduction in output of 2 to 4 percentage points of GDP and sending unemployment surging back toward 10 percent.
Sounds dire, and in fact it would be if allowed to proceed unabated. Yet while there is little hope for an election-year agreement, the odds favor a substantive compromise early next year that resolves much of the uncertainty that is presently suppressing investment and job creation. Even a modest deal that defines the rules of the game for the next few years would be bullish for stock investors. Considering the alternative, this seems likely.
Congress has created a stink bomb that is scheduled to go off on Jan. 1. All of the Bush tax cuts are scheduled to expire, having been temporarily extended back in 2011. This means that the top marginal federal tax rate jumps from 35 percent to 43.4 percent after tacking on the new taxes mandated by the Affordable Care Act.
Capital gains taxes are slated to rise, and dividends would henceforth be taxed as ordinary income. Meanwhile, the estate tax rate jumps from 35 to 55 percent, and the current $5 million exemption reverts to $1 million. In addition, the temporary 2 percent reduction in the Social Security tax paid by employees goes away, and the AMT patch which expired last year starts to bite millions of middle-class taxpayers.
On the spending side, the potential carnage is arguably even worse. Thanks to Congress' inability to resolve the puerile dispute over the debt ceiling, mandatory sequestration of government spending takes effect chopping $110 billion from federal outlays in 2013 (including devastating cuts to the Defense budget).
Taken together, the tax hikes and spending cuts would suck $607 billion out of U.S. economic activity next year, according to the Congressional Budget Office. Estimates of attendant economic damage vary, but range from merely recessionary to potentially disastrous. Regardless of the outcome at the polls in November, some kind of accord is essential and inevitable. The can is at the end of the road.
Given the urgency of the gathering storm, the 113th Congress is likely to reach agreement on a tax and spending regime that provides sufficient stability and visibility for investors and corporations to begin moving off the sidelines. A modicum of clarity and predictability regarding tax policy is likely to unleash a wave of capital investment by U.S. firms (especially job-creating small businesses), setting off a powerful rally in equities. Investors might consider using the rest of the year to review portfolios, capture some profits, and position themselves for a more bullish outlook in 2013.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at email@example.com.