Three Implications of a Fiscal Cliff Tax Hike

December 10th at 11:20am by Russ Koesterich -- BlackRock Chief Investment Strategist

From the outside, it’s hard to find much evidence that Washington is getting closer to a fiscal cliff deal. Perhaps there is more going on behind the scenes than the headlines suggest, but as of today it is hard to find much evidence that the odds of a deal have risen.

As the potential for fiscal drag rises, it is worth reiterating why this is so dangerous. From my perspective, the biggest risk to the economy, and to financial markets, comes from the tax side of the equation.

To review, the fiscal cliff comprises a series of tax hikes, including: marginal tax rates, payroll taxes, capital gains, taxes on dividends, estate taxes, and a new 3.8% tax on non-wage income for high earners. In addition, without legislative action, the alternative minimum tax (AMT) will hit millions of more Americans. In aggregate, the combination of these tax increases and new taxes will equal roughly $400bn.

While the $400bn figure is normally compared to overall gross domestic product (GDP), a more relevant comparison is against disposable income, which will take a direct hit as a result of these tax increases. US Disposable Income is currently a bit below $12 trillion, which means the tax increases, should they last the full year, represent roughly 3.5% of what Americans take home on an annual basis. As I’ve argued in past, this is a very large tax hike.

Also, it will be happening at a time when income growth is already very slow. As of October, disposable income was growing at around 3.5% year-over-year, half the 50-year average. For hourly workers, the situation is even worse. Hourly wages are growing at little better than a 1% year-over-year pace. The tax hikes, particularly the jump in the payroll tax, will hit hourly workers hard.

Should these tax hikes hit, and remain in place, there could be several implications:

  1. Potential recession.  Most importantly, a tax hike of this magnitude set against a weak expansion will probably lead to another recession as consumers are forced to pull back on spending.
  2. Unusual trading. Next, we are likely to see a continuation of a very unusual end-of-year tax trading – namely, investors selling winners to minimize capital gains liabilities.
  3. US market underperformance. Finally, we expect to see international markets outperform the United States. Since peaking in September, the S&P 500 is down roughly 4%. In comparison, the MSCI? ACWI-ex US Index is within a few points of its September high.

One thing we don’t expect to happen – a massive sell-off in dividend stocks. We have maintained for some time that with the exception of US utility stocks, we don’t believe the dividend space is more vulnerable than the broader market. Since the September high, the two US iShares dividend funds, the iShares High Dividend Equity Fund (NYSEArca: HDV) and the iShares Dow Jones Select Dividend Index Fund (NYSEArca: DVY), are performing in- line with or better than the S&P 500.

While Washington is, at least in theory, capable of compromise, time is running short. While a plunge over the fiscal cliff can be rectified in 2013, investors are justified in being cautious. Until we see the parties move off of their entrenched positions, we’d embrace three strategies: stay defensive, don’t abandon dividend stocks, and favor international equities.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock.

There is no guarantee that dividends will be paid. Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

BlackRock does not provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.

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