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As the nation goes to vote today, there are several significant scheduled tax and spending changes that will have to be addressed by whoever resides at 1600 Pennsylvania Ave.  Collectively, these are referred to as the “fiscal cliff”.  I thought a quick recap of these potential changes and a discussion of their likely impact would be helpful.

If a new budget agreement can’t be reached by the end of this year or early next year, federal spending gets automatically trimmed – sequestered – by $70 billion through September 30, 2013, about half of it from the defense budget. In perspective, government spending will be about $2.7 trillion from January to September 2013. So, we’re only talking about 2.6% of total spending – or 0.6% of GDP – over the last nine months of the fiscal year, which ends September 30.  Note that we’re not talking about anywhere near $1 trillion in cuts.  That amount is often referenced in discussions about the fiscal cliff, but this is the amount of savings that is supposed to be achieved over 10 years.  The actual annual amount is $109 billion per year.  The $70 billion referenced above is the amount of cuts mandated over the remainder of the current fiscal year .

Nonetheless, these cuts would no doubt hurt defense contractors and other recipients of government business and aid. But on the flip side, we need to understand that government spending crowds out spending from the private sector, so cutting government spending by this little, freeing up capital to be used by the private sector, and showing that Washington is starting to get its fiscal house in order would probably have a net positive effect on GDP, even in the short-term.  As a frame of reference, government spending was cut about this much at the end of the first Iraq War in 1991, and the economy grew.

More worrisome is the tax side of the fiscal cliff. The major items include:

(1) The end of the 2% payroll tax break of the past two years – $120 billion in extra revenue per year.

(2) A new extra 3.8% tax on dividends, capital gains, and interest income and a 0.9% Medicare tax on high earners – $25 billion/yr.

(3) Lower thresholds for the Alternative Minimum Tax – $100 billion-plus.

(4) A return to the 2000 tax rates on income, dividends, and capital gains, including a top official rate of 39.6% on ordinary income and dividends and 20% on capital gains – $150 billion-plus.

The consensus among economists we trust is that the odds of a recession as of this writing date are probably 25%.  We have been fairly consistent in our assessments that the economy is not heading into a recession, and we reaffirm that assessment now.  That, of course, is dependent on our reading of what government policy is likely to be in the fiscal realm.  If all of these tax hikes happen at once, the odds of recession shoot up quickly.   It’s tough to put an actual value to that probability, but the more important issue is the probability of all these tax hikes being imposed.  In other words, how likely are the politicians in Washington to impose this burden on the economy and, more importantly, on their constituents who will return to the voting booth in two short years.

The best guess is that the 2% payroll tax cut won’t be extended again. That, by itself, is not cause for much concern. Personal income is up $460 billion in the past year, so workers have enough income growth to absorb a reversal of the payroll tax cut and still increase their purchasing power. The economic expansion would survive.

The real threat is a simultaneous impact on investment and work effort from higher marginal tax rates on ordinary income, dividends, and capital gains combined with the unsettling impact on consumers and investors of losing a significant portion of their expected cash flow.

These tax hikes would not only damage the supply-side of the economy, but would subtract hundreds of billions of dollars of income from the private sector. Both sides of the political aisle understand this.  This is not in anyone’s best interest.  Notwithstanding President Obama’s assurances during the last debate that the fiscal cliff won’t happen, we have always believed that the odds heavily favor some agreement being reached (as it was in 2010) regardless of the outcome of the election. Given the President’s statement, those odds only became more favorable.

Even after today’s election, that agreement probably won’t come very quickly; both parties have an incentive for brinksmanship to drive the best possible bargain for their supporters. We will have to wait until the last days of any lame duck session.  Also keep in mind that the “cliff” doesn’t occur right at the beginning of 2013.  The impact of the changes will be gradual at first, and Congress can act to change laws retroactively after the January deadline. As a result, the fiscal cliff won’t necessarily be an impediment to growth even if Congress doesn’t address the issue until after 2013 has already begun.

The odds still favor avoiding a recession.  If there are some tax increases, they probably won’t be anywhere near high enough to cause a recession, and there may not be any tax increases at all.  The US economy should continue to grow right through 2013 (odds in favor at 75%).  How fast it grows is an issue we’ve addressed fairly consistently over the last several years.  Under current policies, and with the uncertainty of various laws that have yet to be translated into actual regulations, we continue to see this economy as a “plow horse” trudging along at admittedly anemic, but still positive, low growth rates.  Whether that changes and improves will be dependent on the actual, concrete policy decisions made next year.  The stock market, always looking forward, “gets” this, and that’s why it’s generally up this year.  Ev en with the gyrations we’ve seen in the last several days, the market is up about 7% for the year (Dow started 2012 at 12,217).  By any normal standard, that is not a bad year, nor is it a performance which signals extreme trouble.

As strong as the odds are for a continuing improvement in the economy (75%), markets will react with much more volatility, especially as the poker game plays out.  The market is betting on the 75% probable event, but will spook should it look at any time as though the 25% probable event is going to occur.  Tax policy and regulatory policy can and will impact that greatly, so public comments, speeches and pronouncements on tax and regulatory policy will also impact the market greatly.

But let’s deal with what we should do if the market drops by 10% or more – whether due to extreme volatility or if there actually is a recession (remember, only a 25% probability of this).  The probability is overwhelming that a drop due to extreme volatility will be corrected quickly.  We would advise buying into that drop – selling some bonds and buying equities – in order to capitalize on a great opportunity.  If the drop is somehow connected to a recession, we also would advise buying into the drop.  This recession would be mild, but the political ramifications would be so large that Congress and any administration would be forced to rectify it.  Remember, with mid-term elections only two years away, we believe the probability is overwhelming that Congressional action with Presidential agreement would reverse whatever policy error created the recession in the first place.  We will want to profit from the recovery.

Worthy of a brief discussion is the question of why we don’t potentially recommend selling out of equities – or lightening their amount – to wait for a potential drop and then buy in.  The reason is simple and compelling.  At this point, we believe there is ample evidence to suggest that the market will not drop and will actually continue to increase gradually and/or increase substantially in a few hectic trading days.  In other words, the opportunity costs of missing either a prolonged gradual continuation of the recovery or of missing a rapid reset upwards are profound.  Getting out or lightening up could easily do more harm than the potential downturn would ever have caused in the first place – literally an out-of-the-frying-pan-into-the-fire scenario.

With regard to tax moves, we are still in a wait-and-see mode.  As we approach year-end, it will probably make sense to harvest any tax losses that exist.  These can always be used, and we can always park the money in an alternative equity to avoid missing out on a run-up.  But the issue of recognizing gains now (at low tax rates) in order to avoid perceived higher tax rates later is more complicated.  If the resolution of the election and the fiscal cliff results in maintenance of current capital gains tax levels, then triggering gains now would not be warranted.  We’ll all have a better idea as we approach December 31st as to what might actually happen to capital gains tax rates and the slew of other smaller tax increases discussed above.  The bottom line is that potential increases in tax rates are in the 10% to 15% range (5% increase in CG + 3.8% Medicare tax + 3% average increase in income tax rates + some increases due to deduction elimination and greater exposure to AMT), but they may not happen at all.  We have time to assess their ultimate likelihood and then react, so we do not need to make that decision now.

In conclusion, the fiscal cliff shouldn’t be an issue, the economy should continue to plug along (but it may well heat up quickly), and tax moves can be better assessed over the remainder of this calendar year.

There’s a lot here, and I realize I may have raised as many questions as I’ve answered.  If you want to discuss these issues or any concerns you have, please call me at your earliest opportunity.