Over the past few months, there has been more talk about the looming US “fiscal cliff” and what the implications would be on the US and the global economy. This would undoubtedly affect the equity and debt markets as well. In the upcoming year, investors may find it difficult to navigate the potential fiscal cliff.
What brought about the fiscal cliff?
In order to understand the effects it is best to start at the beginning of what brought about what is known as the “fiscal cliff”. When President George W. Bush took office in 2001, the US had a budget surplus of $230 billion due to the boom years of the 1990s. In order to cut the budget surplus in 2001 and 2003, President George W. Bush lessened the future tax burden to taxpayers by signing into law two different tax bills. The first law was the Economic Growth and Tax Relief Reconciliation Act of 2001. Then in 2003, the Jobs and Growth Tax Relief Reconciliation Act was enacted. These two laws together are referred to as the Bush-era tax cuts.
Prior to the Bush-era tax cuts, the highest marginal tax rate for an individual was 39.6 per cent and the tax on dividend income and short-term capital gains were at a similar rate. After the change in tax, dividends were taxed at a much lower maximum rate of 15 per cent or less than half the prior tax rate and long-term capital gain taxes were reduced even further. The tax laws also increased the child tax credit, erased the higher taxation of married individuals and greatly reduced the estate tax.
The bills were passed with strings attached. It was agreed that the bills came with an expiration date, a “sunset clause”. The sunset clause meant that all these tax cuts enacted by the 2001 & 2003 tax acts will expire at the end of 2010 and that tax rates will revert to their much higher 2001 rates.
In 2010, Republicans gained a bigger foothold in the House and Senate and pushed to extend the tax cuts for another two years, until the end of 2012, for all taxpayers. It was also accepted by the Democrats because it was considered imprudent to increase taxes given the fragility of the US economy.
The fiscal cliff is the expiration of the Bush-era tax cuts without a plan in effect to extend or restructure them. Since 2001, the fiscal budget surplus has become a significant fiscal deficit. The Democrats want to raise taxes either by letting the Bush-era tax cuts expire or by keeping part of the tax cuts for lower wage earners while keeping the higher tax rates for higher income individuals. Whereas the Republicans and the Tea Party movement want to keep the tax cuts since they generally feel that the government collects more than enough money to provide basic services and that the government needs to shrink and manage the Federal Budget better.
Implication for companies and individuals
The implication of not extending the tax cuts is that companies and individuals who are making plans for next year will have no vision of what the future will bring. There is great uncertainty on what their tax liability will be in the coming year. Therefore, it is difficult for individuals and corporations to make decisions on capital outlay commitments.
According to a 15 September, 2010, article by Forbes, the tax impact could be huge for a family. In the article, he cites that Deloitte Development LLC came up with several tax scenarios. Some scenarios estimated that the expiration of the Bush-era tax cuts could cause increases in taxes of at least 15 per cent for some middle income individuals and as much as 113 per cent for some middle income families.
It is argued that a potential pull-back in corporate and individual spending could dramatically slow down the economy to the point of throwing the US back into a recession.
Implication for the stock and bond markets
Current tax laws provide a benefit to owning stocks over bonds. Qualified stock dividends are taxed at a maximum rate of 15 per cent whereas interest income from bonds is taxed at a maximum marginal rate of 35 per cent. With the expiration of the tax laws, the incentive to own stocks over bonds will be thwarted because dividends will be taxed at the same rates as interest income.
The increased taxation coupled with the lower spending and lower economic growth could cause investors to back away from the stock market and move towards holding more in cash or bonds over the coming year. With a change in the tax laws, you could see many US-based investors changing their preference from higher dividend yielding stocks to lower dividend yielding stocks with higher growth rates to reduce their tax burden.
Although the scenario of not extending the Bush-era tax cuts is not certain, it does make investors feel less sure about their future and the one thing the market does not like is uncertainty.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.