U.S. Fiscal Cliff – Are we there yet?

As we anticipated, the US political leaders come together at the eleventh hour to finally agree on tax reforms and pass the Senate approved bill through the House of Representatives. The outcome spurred equity markets.

At the heart of the deal is the extension of lower and middle income Bush tax rates with tax increases being levied on incomes above US$450,000 (including raising investment income taxes to ~20% from 15%). As expected, the payroll tax holiday was allowed to lapse on schedule. Moreover, Emergency Unemployment Compensation was extended for another year. The sequestration associated with the Budget Control Act was deferred for two months. The fate of these across the board budget cuts in late February / early March remains uncertain. This uncertainty, combined with the unresolved fate of the debt ceiling, probably dampens any "certainty bounce" in confidence that would be expected with the resolution of the fiscal cliff. One element of the agreement that has raised some confusion is the limited deductions allowable for higher income earners. What this limitation does is reduce the allowable itemised deductions by 3% of the amount by which a taxpayers adjusted gross income exceeds a certain threshold.

Bill Specifics:

§  Top income tax rate increased to 39.6% from 35% for household income above US$450,000 and individual income above US$400,000.

§  The top rates on capital gains and dividends would increase to 23.8% starting at the same income thresholds.

§  Limits on personal exemptions and itemised deductions for top earners that had been phased out will return, for individuals starting at $250k, and married couples starting at $300k.

§  The payroll two-percentage-point tax cuts lapsed, raising taxes on 77.1% of US households.

§  The bill extends unemployment benefits for two million Americans; extends tax credits for child care and college, and for renewable energy production.

§  Delays automatic cuts scheduled to start this month by two months, offsetting the US$24bn cost with a blend of additional revenue and spending reductions, half of which would come from defence.

In nutshell, the bill has increased taxes by US$620bn and cut spending by US$15bn. It is estimated that the top 1% or those with incomes over $506,210 would pay an average of $73,633 more in taxes.

It is estimated that the payroll tax cut expiration and higher taxes for top earners will probably slow the economy, reducing growth in the first quarter to 1% from 3.1% in 2012‟s third quarter. The deal can be evaluated only in combination with the result of the next fiscal talks, to be concluded by the end of February.

It is important to reiterate that this deal does not spell an end to the cliff debate, with significant headwinds still remaining. A series of „cliffs‟ are still looming, and in approximately two months US politicians will need to contend with the tax cuts that have simply been kicked down the road, together with the more pressing issue of the elephant in the room – the US$16.4 trillion debt ceiling. Congress must act as early as mid February to prevent a default and the dispute may reprise a similar 2011 episode that led to a downgrade of the U.S. credit rating. This all comes at a time where the divergence in ideals between the two political parties remains significant and the way in which the US will achieve fiscal consolidation remains far from clear.

Indices:

The Australian All Ordinaries Index has moved up increasing +65 points (or +1.3%) since closing last Friday to 03:15 pm today.

The rest of the world as measured by the MSCI index increased +2 points (or +0.2%) in A$ from closing last Friday to end of trade Thursday.