Bear Mountain Capital Inc.

Do Not Make Me Say It Again…

| December 7, 2012


Nearly, every parent or child has uttered or heard the words “Don’t make me say it again…” at some point in their life. That is exactly the thought that comes to mind when I think about the dominating headline of the day: Fiscal Cliff. There I said it, but don’t make me say it again. It is exhausting to discuss the legislative gridlock we’ve experienced going on 3 years now. This dirty little phrase is meant to describe the automatic spending cuts and tax-cuts expiration that are coming due on January 1st. It is a high-stakes poker game between the two main political parties, but the risks to the economy in the short-run and the long-run are not entirely clear.

Many economists believe that if January 1 comes with no deal, then the drag on the economy will be a negative 2% to 2.5% GDP. So, if economic growth is averaging 2% to 2.5% annual growth, that could wipe out any economic progress in 2013. It may not throw us into a full-blown recession, but it increases the odds. The upside to this scenario is that the automatic spending cuts and increased tax-revenue put the US budget on a fiscally sustainable path. The downside is there are more intelligent ways to managing our country’s fiscal affairs.

The other reality, is if the deadline passes with no deal, the impact of the automatic spending cuts and increased tax rates will not be felt immediately. It could take months for these changes to ripple through the economy. This provides enough time to strike a deal, after the deadline. Such a deal could be retroactive in nature, offsetting spending cuts or increased tax rates well after January 1. This makes the deadline more of red herring for the two political parties, then a real deadline for fiscal impact on the domestic economy.

What investors, businesses and consumers alike would prefer to see is that a big fiscal compromise between the two parties happens before year-end. This scenario, while not likely, would do a lot in boosting investor confidence and spur business investment. The one thing businesses and investors do not like is uncertainty. The details of the deal are not as important as the actual completion of a deal as long as it is balanced and significant in nature.

You will hear much alarming rhetoric regarding massive cuts to medicare/social security or dramatic tax “hikes”. To be sure, any good deal will cause some sort of “pain” for nearly every American. If a broad “grand bargain” can be struck between the two parties, the result will be a stronger, more vibrant economy in the long-run.

The impact on you, if Congress misses the January 1 deadline will be varied. If no deal is struck, market volatility will increase, tax rates will go up and social services, as well as defense spending will be curtailed to some degree. This will slow down economic growth and leave us in a more fragile economic state, then we are in today. Will it be devastating, as the two word catch-phrase suggests? No. Will it be felt? Yes. It will lead to uncertainty about future economic growth as consumers and business alike adjust to the new economic reality.

The likeliest scenario is some deal is reached, either by January 1 or shortly thereafter (with retroactive provisions). This deal will include cuts and it will include higher taxes, but mostly for individuals making over $250k a year. Their rates would go up from 33% to 36%. Individuals earning more than $400k a year would see their taxes go up from 35% to 39.6% (may be 37%, if there is a rate compromise, which is being floated by aides of both sides).

The one tax that will affect most people, high-income or not, is that the current “Qualified Dividend” tax rate will go up from the fixed 15% where it is today to the marginal tax rate (ordinary income tax rate). So, this will affect more individuals. Fortunately, most of the portfolios managed by Bear Mountain Capital earn income from non-qualified dividend income, and will not feel much affect from this change.

Lastly, long-term gain tax rate will increase to a top rate of 20%. I’ve been asked should we take gains now, as a result? The answer is “most likely not”, unless there is a major known liquidity need in early 2013 that you must meet. The reason not to make a change solely on this tax rate going up, is that the gains in our portfolios will not be realized for years in most cases. And when they are realized, the tax rate at that time may again be different then it is projected to be next year. Its better to let the assets continue to grow at a compounded rate, then it is to force a “realized gain” event, if the bulk of the money is not going to be needed for 10 years or longer.

Hopefully you will not hear from me again on this topic, but that may be wishful holiday thinking. In the mean time, I hope you all enjoy time with close family or friends this holiday season and I look forward to talking with you in the new year on an entirely different subject.

Warm Regards,
Joe Day