A Tax Cliff or a Bridge?

Post-election the fiscal cliff emerged as the worry du jour. Geographically the cliff is a daunting hill, as in “Capitol Hill.” Economically the cliff is a January 2013 drop dead date as the Bush tax cuts expire, the Social Security payroll tax holiday ends, the Affordable Care Act taxes kick in, and major federal budget cuts are applied under the sequestration process. Mentally, the cliff is a vexing unknown for investors.

 The House, Senate, and the president must agree on a deal to avoid what could be a colossal mess effective January 1. There are but three possibilities—a Thelma and Louise scenario where the economic recovery sails over the cliff as our leaders play a game of “economic chicken”; a “kick the can down the road” maneuver based on a modest compromise with key issues pushed further out; or, the grand bargain, our leaders come together with a solid bi-partisan plan that deals with fiscal issues, spending cuts, and tax policies that spur growth incentives. If that happened, uncertainty would ease and billions of dollars on the sidelines could flow back into markets. Color the “grand bargain” as unlikely in the short run. There isn’t enough time.

 We may not have resolution until mid-to-late December—if then. Most likely is a classic Washington response to a major challenge, a one to two year punt. On November 6, House speaker John Boehner told CNN, “Lame-duck Congresses aren’t known for doing big things and probably shouldn’t do big things, so I think the best you can hope for is a bridge.” Is our cliff now a bridge...a bridge too far?

 President Obama wants to raise tax rates on those making $200,000 or more single,  $250,000 joint. In his debate with Paul Ryan, Vice-president Joe Biden signaled a potential alternative, saying tax increases would start with million-dollar earners—a level that could be more palatable to lawmakers. Another Biden gaffe or a clue to compromise?

 One reason to anticipate a deal is the debt ceiling. The U.S. is about to bump up against the debt ceiling again, the legal limit on government borrowings. Now at $16.4 trillion, Congress will have to act to raise the ceiling or risk sending financial markets into a twit. The president may not wish a nasty fight at this juncture on overall fiscal cliff contentions since failure to reach agreement on the debt ceiling would hobble federal attempts to deal with massive running deficits.

 Investors sitting on locked-in long term capital gains may be heading for the exits, fearing a major increase in capital gains rates plus Medicare taxes. If you intend to harvest capital gains this year, notify your advisor and custodians early. December could be a zoo if everyone waits until the last minute. Accountants and tax lawyers already are busy dealing with tax strategies and most likely will be strained as January  approaches.

 Are stock market bears eyeing the cliff? Some analysts take investor fears as a contrarian signal. Money management sage Richard Bernstein, named top investment strategist by Institutional Investor ten times, cites an absence of three classic bear market signals—a interest rate yield curve inversion (a situation where long-term debt instruments have a lower yield than short-term instruments of the same credit quality), extreme overenthusiastic investor sentiment, and lofty stock price valuations. (Financial Advisor magazine, November 2012).

 The upshot? Taking capital gains, especially on concentrations of low tax basis stock, may be wise. If the bulk of your assets are in retirement plans, harvesting gains is not a tax issue. If you are well diversified and have ample cash reserves and liquidity, there is no need to hit the panic button over cliff worries. As Winston Churchill observed, “Americans can always be counted on to do the right thing...after they have exhausted all other possibilities.”

Lewis Walker is President of Walker Capital Management LLC and Walker Capital Advisory Services, Inc., a Registered Investment Advisor (R.I.A.) Securities and certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA).  Lewis Walker and Mike Hostetler are registered representatives of SFA which otherwise is unaffiliated with the Walker Capital Companies.