Investing

Fiscal Cliffhanger for Investors

If all of the tax hikes and spending cuts take effect, stock prices could fall 10% to 20% by year-end.

England has the White Cliffs of Dover, and Ireland has the Cliffs of Moher. Now the U.S. has a “fiscal cliff.” The term, coined by Federal Reserve chairman Ben Bernanke, alludes to the $550 billion in tax hikes and spending cuts that will take effect automatically on January 1 unless Congress and the President take action to prevent it. If they fail to act, the economy will tumble over the cliff and likely sink into recession in 2013. And, as we know, recessions are bad news for stockholders.

The Numbers

More than half of the total comes from the expiring Bush tax cuts that were enacted in 2001 and 2003. These cuts lowered marginal income tax rates for all levels of earned income and cut the top income tax rate on capital gains and dividends to 15%. The estate tax exemption is also set to change next year, falling from the current $5 million to $1 million; the top estate tax rate will revert to 55%. And if that weren’t enough to scare affluent investors, a 3.8% Medicare tax surcharge will be applied for the first time ever to capital gains and dividend income for couples earning more than $250,000.

The good news is that neither the Democrats nor the Republicans want all the pre–Bush era tax rates to return. President Obama is proposing that the tax cuts be maintained for “middle income” taxpayers (and in fact the Democratic Senate passed a bill to do just that in late July). But he also wants the rate on earned income, capital gains and dividends to revert to the pre-Bush levels for higher-income taxpayers. That would mean individuals or families earning more than $250,000 would see their marginal tax rate rise from 35% to 39.6%, the capital gains tax rise from 15% to 23.8% (including the 3.8% Medicare tax), and the removal of all tax preferences for dividend income.

Higher taxes on gains and dividends would be an additional drag on stocks, especially when tied to a possible recession next year. If no compromise is reached, the negative impact on stocks will increase as January 1 approaches. In the worst-case scenario—that is, if it appears that all of the tax hikes and spending cuts will take effect—I estimate that stock prices could fall by 10% to 20% by year-end.

Both parties seem willing to deal on dividend and estate taxes. But the issue on which there is no sign of compromise is the reduction in the tax rate on those making more than $250,000. The Democrats contend that high-income individuals have benefited the most from economic growth over the past two decades and should shoulder a bigger share of the burden of closing the deficit. But Republicans argue that all of the tax cuts should be extended at least into 2013, leaving resolution of this debate to the next Congress. Clearly, the GOP thinks that, with a chance of taking control of the Senate and winning the White House, its political clout will increase after the elections. Democrats, however, believe an Obama victory will strengthen their hand.

Still, the Democrats may be persuaded to vote for an across-the-board extension of current tax rates into 2013. Any such extension would have a powerfully positive effect on business sentiment and stock prices. A recent study by the research group ISI indicates a strong correlation between stock market results and a president’s approval rating. Obama might reason that with nearly half of all Americans holding stocks, either directly or through a retirement plan, his candidacy might benefit from a rising stock market.

But a compromise may not come until after Election Day. At that point, the Democrats and the Republicans could decide to extend current tax rates for a year until we can reform our tax code. Perhaps this Congress, which has been lambasted for doing so little, will do something good for the economy before it adjourns. If so, we’ll see a strong end-of-year stock market rally.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania’s Wharton School and the author of Stocks for the Long Run and The Future for Investors.

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