No fiscal cliff, but tax hikes loom.

No fiscal cliff, but tax hikes loom.

Despite this being an election year, congress won’t allow the country to drive off the so-called "fiscal cliff," the combined increase in tax rates and mandated spending cuts that some fear could throw the country into a deeper economic malaise. At the end of the day, Republicans will likely compromise with Democrats and the president on raising taxes for affluent Americans, said political consultant Andy Friedman from The Washington Update.

“One way or another, we’re not going to see the full brunt of the fiscal cliff, and I think it’ll probably come in the lame duck session, or maybe necessarily shortly thereafter where we end up with some tax increase on wealthy Americans, and maybe next year we then have a vigorous effort in tax reform to try to change the whole code,” Friedman said, during a webinar hosted by Sammons Retirement Solutions on Thursday.

The Bush tax cuts are set to expire at the end of the year if Congress does nothing; that will provide extra revenue for the government and put off the deficit issue for a few years, Friedman said. But the government also agreed on $2.1 trillion in spending cuts, including $1 trillion in defense cuts, which begin next year. At the same time, you need about $2.50 to $3 in spending cuts for every $1 in tax increases, but this would be $3 in tax increases for every $2 in spending cuts. That doesn’t bode well for next year.

The “fiscal cliff” is the expected slowdown in the economy that could occur if taxes go up as high as they will and the mandated spending cuts kick in, hobbling the economy. Economists are concluding that the combination could result in a 3.5 percentage point slowdown in GDP, which would throw us back into recession, Friedman said.  

But Friedman believes Congress won’t let that happen. It will be hard to derail the spending cuts; Moody’s and Standard & Poor’s have said they’ll downgrade the U.S. credit rating again if spending cuts don’t take effect, though the previous downgrade of U.S. debt by the agencies had little effect. Republicans in Congress don’t want to see taxes go up, but if they fold their arms and do nothing, then the Bush tax cuts expire, raising taxes on everone. President Obama wants to raise taxes on families with over $250,000 in income. Any comprimise will likely entail some higher tax rates on affluent Americans.

“I think it ultimately it comes down to what the president wants; the president has said it’s time to let the tax cuts for the wealthiest Americans expire,” Friedman said. “So if you start compromising, they’re actually doing a reduction.”

Friedman expects Republicans to make a sacrifice, proposing to keep taxes where they are for the middle class and raise taxes only families with over a $1 million in income. “I think the president will accept that compromise.”

However, this tax reform may not occur during the lame-duck session—the period between Thanksgiving and Christmas. If we have tax reform next year, it won’t be effective until 2014. “So we know we’re going to have a year, I believe, at higher tax rates.

Since the Supreme Court upheld the healthcare reform legislation, we at least know we’ll see a 3.8 percent additional tax on investment income for those earning $250,000 or more. That additional tax was part of the reform.  

“I think the prudent thing to do is to plan for higher taxes, at least for more affluent clients, by which I mean clients that are earning $200,000 and up,” Friedman said.

Volatility Ahead

While the summer months brought a fairly flat stock market, with low levels of volatility, Friedman expects the markets to be exceedingly volatile the rest of this year.

Markets are volatile in an election year anyway because there’s uncertainty around who is going to win. Markets typically settle down after elections because you have certainty, but Friedman expects the markets to get even more volatile after the election, as we worry about a possible recession, the fiscal cliff, taxes and the lame-duck session.

As people plan for the increases in taxes, that will likely also contribute to volatility, as they sell off assets, businesses, and concentrated stock positions before the end of the year.

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