In addition to these tax increases, $1.2 trillion in negotiated spending cuts and another $1.2 trillion in automatic “sequestration” cuts are also scheduled to take effect beginning in January of 2013.3 The Congressional Budget Office (CBO) estimates that the combination of policies under current law will reduce the federal budget deficit by $607 billion, or 4% of gross domestic product (GDP), between fiscal years 2012 and 2013. If not amended or renegotiated, $6.4 trillion in tax hikes and spending cuts would result in roughly a $600 billion drag on the economy each and every year for the next decade.
At a time when the Federal Reserve has used extraordinary means to see that deflation does not take hold in the United States, a fiscal policy this austere would likely reduce after-tax income, increase unemployment and reduce aggregate demand. Not only would such a policy risk tipping the U.S. into recession in 2013, it would also increase the country’s odds of entering a debt-driven, deflationary spiral. Thus, if rates rise and spending is cut because no action is taken in the lame-duck session, we would expect the new Congress, fueled by public outrage in 2013, to reach a new negotiated agreement with the president that restores cuts in defense and domestic spending and that reverses some of the tax increases affecting lower- and middle-income Americans. However, higher tax rates on the highest-income Americans could well remain one of the legacies of a second Obama term.
We expect volatility in equity markets to increase between now and the end of the year. Since a failure to resolve the “fiscal cliff” could tip the economy into a politically induced recession for the first half of 2013, I expect the market to trend lower between now and the end of the year, discounting the possibility that a deal will fail to materialize. I believe Wall Street underestimates how difficult it will be for an agreement to be reached. I believe the president will couch the debate in terms of his wanting to maintain existing rates for 98% of American taxpayers and, in effect, force the Republicans in the House to part their lips and raise taxes on the top 2% of taxpayers. Unless Congress is willing to pass another increase in the debt ceiling that takes that issue off the table for President Obama’s second term, I do not believe the White House will negotiate on this issue. Fasten your seat belts for another round of fiscal chicken.
To understand what impact higher dividend tax rates could have on the U.S. equity market, please see recent research from WisdomTree.
1This description of the new marginal tax rates set to take effect in 2013 does not account for the elimination of itemized deductions, which could make the actual rates that high income earners pay even higher (source: Congressional Budget Office).
2“Officials: Obama Ready to Veto a Bill Blocking ‘Fiscal Cliff’ Without Tax Hike For Rich,” The Washington Post, October 17, 2012.
3Bob Woodward, “The Price of Politics,” Simon & Shuster, 2012, p. 366.
Luciano Siracusano is chief investment strategist at WisdomTree Investments (NasdaqGM: WETF). This post was republished with permission from the WisdomTree blog.
