Out With the Old, In With the Same Old

As we’d largely predicted for sometimenow, Congress reached an 11^th hour fiscal cliff “compromise” on New Year’s Day, providing a huge dose of clarity. That won’t leave folks without things to grumble and stew about as 2013 kicks off—did Congress do enough in terms of taxes? What about spending—will they make cuts at all? Enough? Too much? And so on. But the upshot is, the fiscal cliff is no longer much of an overhang—which should provide the market a measure of relief.

The media reaction, however, seems more focused on who “won.”

Which in some senses is a rather silly way to think about this whole thing because when it’s all said and done, whether Republicans or Democrats “won” the debate should matter far less than the ramifications for the US economy in the years to come. But that’s not how politicians (or the media) really see it, so instead, we’re left with some gnashing their teeth, some proclaiming victory for Democrats and some claiming utter defeat for President Obama—in short, no one’s really happy with the deal. (As a side note, to an extent, that’s guaranteed in all political interactions because of Prospect Theory—the idea people are hardwired to dislike losses some two and a half times as much as they enjoy the prospect of gains. Meaning even if there are winners on both sides, the losers’ sense of loss will outweigh the winners’ sense of gain—the deck’s stacked in favor of dissatisfaction.)

So what really happened? Well, some taxes are going up, some aren’t and the argument about whether any spending will get cut has been pushed off roughly two months—setting up the next (no doubt heated) debate nicely on the debt ceiling. (If you want more of the major details, we’ve outlined the basics at the end of this article.)

However from a market perspective (which is what concerns us most), in one sense, the details don’t matter all that much. As we’ve said before, we’re unaware of any instance in which marginal tax rate changes directly caused a recession or bear market—or were even a major contributor. And though taxes on the highest earners are going up, President Obama compromised some and slid the threshold on those considered “wealthy” up, meaning an even smaller group than originally anticipated will see income taxes increase this year.

Then, too, what seems more important about the tax code compromise is many of the provisions have been made “permanent.” (You read that right—the Bush tax cuts were made permanent by President Obama. Does that mean we call them the Obama tax cuts now?) Now, on one hand, it’s important to recognize nothing in politics is truly permanent. But on the other, what this potentially helps us avoid is a progression of never-ending mini-cliffs ahead as we run into continual expirations on current tax rates. This doesn’t mean rates never change again, but it helps lower the likelihood we have the conversation with quite the (rather contrived) urgency of the Fiscal Cliff debates.

On the spending side, we’ve also discussed before the idea our current spending level is entirely affordable—tied primarily to the fact we’re paying exceedingly low interest rates on our debt for now. Will that always be the case? Possibly not. But is that an imminent (meaning a next 12-18 months) concern? Very probably not.

So what we’re essentially left with is pure political theater. The fact part of the can was kicked down the road is not one whit surprising to us—in fact, we would’ve been shocked if politicians had actually found a way to resolve all the issues at hand in a more permanent manner. Not because we doubt they could’ve actually been that diplomatic, but rather because that would’ve made it much more difficult for them to guarantee their own future fundraising wedge issues. As it is, now we’re guaranteed rather the opposite—that we’ll continue hearing about spending at least (and probably taxes, too) ad nauseum and infinitum.

But that’s not too new, either. If you look back through historical headlines, politicians have always squabbled over whether to raise or lower taxes to support more or less government spending. The conversation about the “appropriate” size of government is the most basic political conversation we’ve always had—starting with the Federalists and anti-Federalists.

What is critical for markets is we finally have some clarity—whether you like the outcome or not. And if market action on New Year’s Eve and Wednesday was any indication, it seems markets were far more concerned about taxes than they were spending (though we’re slightly skeptical of conclusions any single news item was the primary market-driver on any given day). Win, lose or draw, markets tend to prefer certainty to uncertainty. So as 2013 dawns, here’s to can-kicking, compromise and clarity—at least for now.

Major Aspects of the Fiscal Compromise

Major measures related to personal taxes:

• In place since 2011, the payroll tax cut will sunset, meaning all workers face a 2 percentage point increase from 4.2% to 6.2%.
• The alternative minimum tax (AMT) was patched for the 2012 tax year, and a new AMT threshold was established along with a plan to automatically index it for inflation in the future.
• The 2001 and 2003 tax rates were extended permanently for taxpayers who earn less than $400,000 as an individual / $450,000 as a married couple.
  • Those who earn more than those cutoffs will now be subject to a 39.6% tax rate, the prevailing rate for most of the 1990s.
• Long-term capital gains taxes will follow the following schedule, tiered by income:
  • 10-15% income bracket: 0% capital gains
  • 25%, 28%, 33% and 35% income brackets: 15%
  • New 39.6% bracket: 20%
• Affordable Care Act taxes on passive income (3.8%) and the Medicaid surcharge on high earners (0.9%) will be implemented.
• High earners will face deduction limitations that could reduce the ability to claim some items.
• Estate taxes: Up to $5 million will be excluded from taxes (this amount will be inflation-adjusted in future years). The rate assessed on amounts above $5 million will rise from 35% to 40%.

Major business tax measures:

• Accelerated depreciation measures were extended by one year to January 2014.
• Alternative energy tax credits extended by one year to January 2014.

• The so-called Dairy Cliff evaporated as Congress renewed the 2008 farm bill.
• Many other smaller tax credits were extended.

Spending:

• Ninety-nine week unemployment benefits were extended.
• All budget cuts slated for 2013 were delayed until February.
• No entitlement reforms.

Debt ceiling:

Not addressed by fiscal cliff legislation.