The fiscal cliff is really two separate events that will be occurring around the same time:
- Increased Tax Rates For 2013 (including the expiration of the Bush Tax Cuts)
- A Dramatic Decrease In Government Spending
Essentially, the government will be taking more money out of the economy via a tax hike (about $400 billion) and putting less money into the economy through spending (about $200 billion). While these efforts are essential to balancing the federal budget, they will likely have a major negative economic impact. Both the tax increases and the budget cuts can be stopped, however that would require the agreement of both Congress and the President. I agree with the analysis of Thomas Kenny that appeared in “What is the fiscal cliff?”
Although both parties want to avoid the fiscal cliff, compromise is seen as being difficult to achieve – particularly in an election year. The most likely result, in any event, is that the problem will linger at least until after the election, and there’s a strong possibility that Congress won’t act until the eleventh hour.
While the most likely outcome is postponement, there are are a wide variety of outcomes in between. Assuming that no compromise is reached, what will happen?
1) Economic Growth Could Be Mildly Negative in 2013
The worst case scenario according to Credit Suisse is negative economic growth in 2013 of -0.5% GDP. However, they don’t believe this is likely. The most likely scenario with the help of some legislative action, in their opinion is positive 1.8% GDP growth. They believe this scenario is already priced into the stock market.
2) Your Income Taxes Will Rise
Married couples making between $59.3K and $71.0K will be hit the hardest with their marginal tax rate rising from 15% to 28%. However, most middle class and wealthy taxpayers would see their marginal tax rate rise around 3%
3) Dividends Will Be Heavily Taxed
The tax rate on dividends is scheduled to rise from 15% to 43.4%, an increase of 28.4%. Interest income and capital gains taxes will both increase by a modest 8.4%.
Should your investment decisions take these changes into account?
In theory, the following should occur if congress and the President cannot pass new legislation to avoid the fiscal cliff:.
- Dividend paying stocks should lose significant value.
- Municipal Bonds should gain value. (learn more about municipal bonds here)
- The default rate on high yield (junk) bonds should rise, making them less attractive.
Am I suggesting that you act on any of the premises above: No and Yes
No. My thinking is very much in line with Stacy Johnson of Money Talks News. His article “Ask Stacy: Are We Heading Off A Fiscal Cliff” is a must read:
I’ll leave my portfolio intact is that I can’t predict the future. While what’s ahead looks scary, if our nation manages to avoid the fiscal cliff, the market could rally – and I don’t want to be on the sidelines if that happens.
The final reason I’m staying the course is the most important: The money I have in the market isn’t all the money I have. I’m diversified – some in stocks, some in cash savings, and some in real estate. That makes it easier to ride out storms like this one.
If you have a huge portion of your portfolio in high dividend stocks or high-yield bonds, you should diversify. Diversification is the best defense against economic uncertainty.