Week 60 - The “Fiscal Cliff”

Situation: "The Fiscal Cliff": Political candidates on the stump, special interest groups, reporters and “talking heads” in the media love to bandy the term about. Hand-wringing and doomsday prophecies abound. How much of this should we (as long-term investors) be paying attention to? The fiscal cliff is supposed to occur because of legislative bills that have already been signed into law by Congress but which have not yet taken effect. The idea is that our present trajectory (under these pending bills) has the adult US population and the country’s economy bolting over a financial cliff en masse come January. “But wait,” you say, “it’s an election year and this smells suspiciously like Vote Getting Behavior!” Our view is that beyond its usefulness as a classical media scare, the fiscal cliff’s effect on investors will probably depend on their investing strategy, i.e., whether you’re investing for the short term or the long term.

Short term investor: The Fiscal Cliff isn’t good because it cuts the US 2013 GDP by 0.5-0.6%. That may not sound like much of a cut but the expected GDP is only 1.2% and would, therefore, be cut in half. Economists predict that this will be enough to stall the economic recovery and perhaps create a recession.

Long term investor: The Fiscal Cliff is good. You’ll feel skippy because government spending goes down and taxes go up. As a result, the government will spend only a little more than what it collects in taxes and fees instead of its current behavior of spending a lot more. In real terms, that means the US Treasury won’t be pushing so many dollars away from the private economy by continually floating larger and larger government bond issues to support the public economy. 

So just what is the Fiscal Cliff then in real terms? 
    a) Taxes on dividends and capital gains will revert to Clinton-era rates. That means capital gains are taxed at a 20% rate instead of at 15%. For middle income households, dividends are taxed at 28% instead of 15%.
    b) And then there’s the Alternative Minimum Tax (AMT) which will revert to its original form. Remember that? It forces everyone to pay some tax even if they’ve been successful in using “tax shelters” to prevent that. The AMT has to be corrected for inflation annually by separate legislation. If it’s not, many middle income households will be taxed at upper-middle income rates, meaning that dividends would then be taxed at a 31% rate.
    c) Take-home pay will fall because the special reduction of Social Security taxes (from 6.5% down to 4.5%) is going to expire.
    d) State unemployment benefits will no longer receive Federal extensions.
    e) The August 2, 2011, legislation that extended the Federal Debt Limit kicks in. Remember how that one came about? Congress couldn’t agree on how to limit spending so automatic cuts of $1.2 Trillion (apportioned 50% to defense spending and 50% to discretionary spending) over 10 yrs will kick in. That means Federal spending will be $120 Billion less in 2013. 

Bottom Line: No politician wants to be the one who cuts government spending and raises taxes. They know they’ll have a tough time getting re-elected because opponents will promise voters more. That means they are careful to inflict pain during the first year of a President’s term and then hope you’ll forget how it felt. By letting Bush-era tax cuts on dividends and capital gains expire as promised, and by having across-the-board cuts in defense and discretionary spending occur automatically and equally in every Government bureau, no politician can be personally blamed: Nobody’s fingerprints are on the legislation.

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