x
Your preference has been saved. Remove your saved preference.
You must supply both a username and a password to login.
You must supply a username, password and token to login.
Sign on
Passport secured login icon  
 
Wealth Management
Asset Management
Asset Servicing
Insights & Research
About Northern Trust
Search go
Click to close drop down menu.
 
Click to close drop down menu.
Financial Intermediary
Learn about asset management solutions designed for Retirement Plan Advisors, TAMPs/Outsourcing Providers, Subadvisory Program Sponsors, RIAs/Financial Advisors and Trust Institutions.
Institutional
Learn about asset management solutions including: global index management, active equity and fixed income, target retirement date funds, and manager of manager programs.
Individual
Get answers to your investment challenges with asset management capabilities including alternatives, exchange traded funds, fixed income, mutual funds and tax-advantaged equity.
Click to close drop down menu.
 
Northern Trust Logo
 
.
 
 
 
 
 
 
 
 
.
.

January 2, 2013

Fiscal Cliff: Now for the Hard Part

Jim McDonald Image/Headshot

Jim McDonald
Chief Investment Strategist
Private Passport Navigation Right Arrow View biography

Download printable PDF

Tuesday evening the U.S. House of Representatives passed the American Taxpayer Relief Act (ATRA), addressing the tax portion of the fiscal cliff, but delaying decisions on the spending part for another two months (for now). This delayed deadline now has the debate on spending coinciding with the deadline to increase the U.S. debt ceiling. The ATRA's accomplishments include extending the 2012 income tax rates for low- and middle-income taxpayers, and limiting the increase on capital gains and dividends. Left unaddressed are questions related to spending – the scheduled cuts to defense and discretionary spending have been deferred by two months, and the ATRA does nothing to address long-term entitlement spending problems. The financial markets' focus in coming months will be split between two competing sights: a gradually improving global economy and a potentially raucous debate in the U.S. over entitlement reform and the debt ceiling. While we expect market volatility to remain elevated during the next several months, we believe the combination of moderate growth and easy monetary policy will carry the day and that portfolios should continue to be positioned for growth through tactically overweighting equities and natural resources, and underweighting investment grade bonds.

 

Economic policy uncertainty has been elevated over the last several years, and the arrival of the fiscal cliff presented an opportunity to add some clarity. On the tax front, important progress was made in permanently extending the Bush-era income tax rates for lower and middle-income taxpayers, while providing certainty around the tax rates on higher-income taxpayers. With respect to investment-related taxes, there was no change to the tax treatment of tax-exempt municipal bonds and qualified dividends and capital gains tax rates rose from 15% to 20% for high-income taxpayers (before the 3.8% Affordable Care Act tax). Both of these are market friendly as there was building concern around the tax treatment of municipal bond income, and uncertainty around how large the increase on dividends and capital gains could be. The top gift, estate and generation-skipping transfer tax rates have permanently increased to 40%, with representative exclusions and exemptions set at $5 million adjusted for inflation. At the end of the day, the finality of the tax negotiations is a constructive step in removing some of the economic uncertainty hanging over the U.S. economy. From a growth standpoint, the permanent extension of the middle-class tax cuts eliminates the largest potential fiscal drag issue. Resumption of the full Social Security payroll tax collection and increased taxes on higher-income taxpayers will represent an approximate 1% fiscal drag in 2013, and implementation of the automatic spending cuts under the Budget Control Act of 2011 (sequestration) would represent further drag of around 0.8% of GDP. Growth will be affected in the first half of the year, but in a more manageable way than if no agreement on taxes had been reached.

Left unaddressed, however, is longer-term spending reductions. The mismatch between U.S. revenue (taxes) and spending is unsustainable at current levels, even before the upcoming increase in entitlement spending. Revenue has fluctuated between 16% and 21% of GDP throughout the last 22 years, while spending has represented between 18% and 25% of GDP. In 2012, the Congressional Budget Office (CBO) estimates revenue of 15.7% of GDP, spending of 22.9%, and a resulting deficit of 7.2%. The U.S. can likely sustain a long-term fiscal deficit of 2% to 3%, meaning we need a 5% reduction from current levels. Federal budget accounting is a complicated matter, and in Exhibit 2 we present some alternative deficit scenarios.



The CBO Baseline scenario, with the lowest deficits, assumes that the laws in place in 2012 continued through the study period – meaning that the Bush-era tax cuts expired and the spending sequestration occurred. Their Alternative scenario, presented to represent a more realistic outcome, assumed extension of much of 2012 policies – including continuing low tax rates and no sequestration. The deterioration in deficits over the time frame is due to increases in entitlement spending – including Social Security, Medicare and Medicaid. Mandatory spending is projected to climb from 13.4% of GDP in 2013 to 14.3% in 2022, while discretionary spending is expected to decline to 5.6% of GDP by 2022 – the lowest level in 50 years. To the mix we have added two computations based on the passage of the ATRA – one assuming the sequestration (based on CBO calculations) and one without it. The latter scenario is useful to isolate what was actually agreed to in the ATRA. Looking out to 2015, the ATRA deal, without sequestration, would still leave a deficit of around $675 billion, approximately 3.8% of GDP, which would then deteriorate through 2022. These various scenarios highlight the necessity of long-term entitlement reform, and why the negotiations over the next two months will be so heated.

CONCLUSION
Passage of the ATRA is a short-term positive for the markets as it provides some needed clarity and finality on tax rates for 2013. The rate increases on higher-income taxpayers were not a surprise, and the broad package of investment and wealth transfer related provisions was generally constructive. Higher-income holders of income-generating investments, such as dividend-paying stocks and municipal bonds, have avoided the potential of much larger tax bills, which should support both of these asset classes. Unfortunately, many of the difficult decisions around spending were deferred for at least another two months and will coincide with the need to raise the U.S. debt ceiling and the expiration of the continuing resolution funding the government. With Democratic and Republican leaders already posturing for these negotiations, we do not expect this to be a smooth process. While this will likely lead to heightened market volatility throughout this period, we expect financial market turbulence to be fairly contained – and we continue to recommend a tactical overweight to risk assets.

Special thanks go to Suzanne Shier, director of wealth planning and tax strategy, for tax policy insights.

IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see https://www.northerntrust.com/circular230.

IMPORTANT INFORMATION: This material is for information purposes only. The views expressed are those of the author(s) as of the date noted and not necessarily of the Corporation and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor’s particular objectives, risk tolerance, tax status, investment horizon, or other potential limitations. All material has been obtained from sources believed to be reliable, but the accuracy cannot be guaranteed.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.