Last minute deal on tax cuts saves billions
In the final quarter of 2012, the dominant headline overhanging the markets was the U.S. Fiscal Cliff. This so called cliff would have resulted in a significant increase in taxes for many American families and a sharp reduction in government spending, if an agreement were not reached. According to some estimates, the combined impact would reduce U.S. GDP by as much as 5%. Such a move would have proved disastrous to the fragile economic recovery, not only in the U.S., but also around the world.
Fortunately, we won’t have the opportunity to see how big an impact these tax increases and spending cuts would have had because a deal was approved in the House of Representatives on New Year’s Day. Passing by a 257-167 margin, the deal will see income taxes will rise for those individuals who earn more than $400,000 and for families with combined incomes of more than $450,000.
Not surprisingly, the tax rate on dividends will be increasing from its current 15% level. What is somewhat surprising is that the new tax rate will be 20% rather than the 42% that many had feared. This will help to provide some level of support for U.S. based dividend-paying stocks. Estate taxes will increase from 35% to 40% and the 2% temporary cut in the combined payroll tax for Social Security and Medicare was allowed to expire.
The biggest drawback to this deal is that it did not fully address the $1.2 billion in spending cuts that were expected to occur over the next decade. Instead, it merely delayed them. On January 2, it was announced that the U.S. had hit its debt ceiling and it must be raised within the next two months, otherwise it could default on its obligations.
We remain cautiously optimistic that a deal will be reached, but the road to reach it is not expected to be a smooth one. It will likely be two months of heated debate and partisan posturing, creating big uncertainty and periods of very high volatility.
Despite the short-term uncertainty, this is a positive for the markets. It will allow investors to once again focus on the economic and market fundamentals rather than the noise. Considering recent numbers, it certainly appears that the fundamentals are improving, which will help to provide support for equities going forward.