Are we headed over the “fiscal cliff” or will our politicians come to an agreement? Your guess is as good as ours, but as there is at least some chance we could go over the cliff, we should spend some time understanding what that would actually mean.
The first impact that most of us will feel from the fall is the loss of the so-called “payroll tax holiday.” For those who don’t follow every tax we pay very closely, the payroll tax is probably better known to you as FICA, or your Social Security and Medicare contributions. For the past few years we have been contributing 2 percent less than we are supposed to into these entitlement programs. Abby Phillips, in an article for ABC News online, says this will mean on average an extra $672 in taxes for people making between $40,000 and $65,000 per year. For higher wage earners it will mean on average an extra $1,135 in taxes.
The second blow comes from income tax hikes, which will impact tax withholdings with the first paycheck of the New Year. Of course it has been well-publicized that the top rate will go from the current 35 percent to 39.6 percent, but in addition, just about everyone will see about a 3 percent increase. Phillips estimates that the average earner in the country making between $40,000 and $65,000 will see an increase of $888 in income taxes. Add that to the payroll tax increase and you are talking about an increase of $1,560.00 for the average American, which will begin to hit paychecks in January.
After these initial blows we will see the impact of the taxing of investments. Dividends will be taxed at ordinary income instead of the current 15 percent rate. Remember dividends are corporate income that has already been taxed at the corporate rate, so this additional tax is icing on the cake for Uncle Sam. This means that for every corporate dollar earned and paid as dividends, the shareholder in the top tax bracket will receive approximately $0.39. Add to that the new health care tax and it drops even further.
Long-term capital gains tax will go up as well, from 15 percent to 20 percent plus the 3.8 percent health care tax. This is one that makes little sense. Capital gains represent voluntary income; one must sell an asset in order to realize a capital gain. If people believe the rate is too high they simply refuse to sell. Warren Buffett assures us that this is not the case, but he is mistaken. Warren will not change his investing behavior, nor will any of his professional investing friends. We will not change either, but that is because rational investors are not going to allow the tail to wag the dog. I have written newsletters on this subject, and for good reason: most retail investors are not rational, and a known tax hit is too hard for them to stomach regardless of how much better other investment options may appear. Others are actually being rational because the capital gain would not only create a tax hit on their investment return, but actually would put them in a higher tax bracket, or worse yet, subject them to the Alternative Minimum Tax (AMT).
In addition to the tax hikes government spending will be cut, especially spending on national defense. The sum of it all points to lower spending by consumers due to lower take-home pay, coupled by less effective distribution of capital as investors will be less willing to realize gains for tax reasons. This will hurt retailers and small businesses the worst, followed by companies with government contracts. In other words: recession here we come.
This all could be at least partially avoided with political compromise, and there have been some positive signals from Congress in that regard. However, until an actual deal is crafted, the cliff remains a possibility. Our best guess is that a stop-gap solution is found followed by more comprehensive tax reform in 2013. That would be much better and at least alleviate the immediate hit on consumers, but it still creates a difficult environment for business leaders to make future plans. Economic activity is likely to be slow in the beginning of 2013 even in the best case scenario.
This brings us to our national holiday. These are difficult times but we still have much for which to be thankful. As is our tradition here is my list.
1. I am thankful that the United States of America is, with all of our issues, still the best place to live and invest within the developed world.
2. I am thankful that I can still run a half marathon even if it does take a little longer than it did when I was in my twenties.
3. I am thankful for my family, immediate and extended.
4. Of course I am still grateful for Mama’s pumpkin cheesecake and my loose-fitting pants that make the enjoyment of said cheesecake possible.
5. Last but certainly not least, I am thankful for you, our clients and friends of the firm. Your trust in Iron Capital is our greatest asset and we value you every day of the year.
Chuck Osborne, CFA