Q&A on the Fiscal Cliff

We have been hearing a lot about the "Fiscal Cliff".  Just what is the Fiscal Cliff and when will we reach it?

The Fiscal Cliff refers to the combination of higher taxes and government spending cuts that will slow down or stop the economy.  All of these are due to take effect in January of 2013.   The biggest changes are:

•       The expiration of the Bush era tax cuts
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•       New health care taxes on upper income families
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•      The end of the payroll tax cut, which was the second largest part of the part of the Obama stimulus program.
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•      Lower discretionary government spending. This will mainly come from the mandatory spending cuts, or so called “sequester”, that resulted from the failure of the so called “supercommittee” to reach a budget deal last August.
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•      A cut in physician reimbursements for Medicare.
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•      The expiration of extended Medicare Benefits
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•       Millions more Americans will be subject to the Alternative Minimum Tax

Estimates are complex and vary depending on the assumptions.  According to research firm ISI, if nothing is done these could add up to $670 billion in higher taxes and lower spending  - read “fiscal drag”, in 2013.  A recent Congressional Budget Office estimate is for GDP to drop to an average of .5% for 2013.  Other estimates vary from zero impact (see below) to 4% drag on GDP, which would take growth negative, and if it persists, cause a double dip recession.

How will the Fiscal Cliff affect investors?

A. The uncertainty will be a weight on investor psychology, which we know drives the
       drives the markets just as much as economic data.

B. Consumer spending will take an immediate hit.  To take one example, the payroll tax cut of about $116B, which was the  second biggest part of the stimulus, will expire.  This could mean
less consumer spending and a decline in GDP.  Some of the numbers we have seen would suggest a 4% GDP decline in 2013, which is big and would reduce our real GDP growth to negative territory.

C. To make things more vulnerable, US growth is already moderating since April.  Coupled with the drag from Europe, our markets and economy could be more volatile and our tepid recovery in jeopardy.

D.  As a result, we might move to a "risk off" environment which would favor low risk assets
like bonds over higher assets like stocks and commodities.

Of course the Fiscal Cliff is no approaching in isolation, and the intereaction with other major market drivers, particularly the EuroZone crisis and election year politics, make things even less predictable.

How do you think the government will handle the problem?

A wide spectrum of scenarios are possible, depending on who wins the presidential election, how much strength the Republicans gain in the Senate, and many other factors.  However, no matter who wins the presidential election, we expect some kind of compromise that will moderate the effects of the fiscal cliff.    The compromise could include a temporary extension of the Bush tax cuts, renegotiation of the sequestration spending cuts and other measures, and may be tied to longer term deal on debt/deficit reduction.  This will be difficult to get done during a lame duck congress and we will likely see another instance of “kicking the can down the road” with temporary measures.

How will this effect business owners and entrepreneurs?
As we approach the fiscal cliff business owners will face more uncertainty.  You can expect businesses  to delay or avoid making decisions about taking risk, investing in new products or services, or hiring workers.  Obviously this is bad for the economy, and it means the economy could slow down even before we get to the fiscal cliff.  If fact this may already be happening, although recently moderating GDP growth could have many causes.

What should individuals do as we get closer to the Fiscal Cliff?

While we expect Congressional action to moderate the Fiscal Cliff, tax rates, ranging from income taxes to capital gains taxes and estate tax will likely go up, and if that weren’t bad enough, a brand new 3.8% health care surtax will be imposed on familes with joint income above $250,000.

However, here are moves we can make to minimize taxes in our portfolios:

We can accelerate income and/or realize capital gains this year.

We can buy high quality tax-exempt municipal bonds where appropriate

Always align portfolios with goals: We suggest that you revisit your goals and long-term asset allocation and make sure they are aligned.  For example, figure out how much you need to protect your lifestyle with low duration tax exempt bonds so that you won't pay more income taxes than necessary.  If you have excess assets, you can consider taking advantage of the higher $5MM gift tax exemption before year-end.

Finally, be smart about asset location, which means what type of tax deferred or trust accounts you used to hold your investments.