04 Jan 2013 The Deficit War

The opening salvos of the deficit war of 2013 have landed with only modest economic and political damage inflicted so far. Mitch McConnell and Joe Biden met under a white flag in the waning hours of 2012 to craft a brief truce to avoid tax hikes that would have crippled the economy. The vast majority of Americans, 99% of them, will keep their current tax rates, though all will see their payroll taxes rise by 2% after a two-year holiday. Unfortunately though, nothing was done to address the nation’s biggest threat – the deficit. The US government still borrows 36 cents of every dollar it spends, at a rate of $1 trillion a year. Those who would change that are ready for a fight.

If the deficit were the only problem we faced, the US would likely be considerably further along in addressing its deficit as the economy seems primed to grow, reducing deficits further, were it not shackled by continuing policy uncertainty.

It’s the deep ideological divisions that threaten real progress on government spending and America’s reaching her true potential. The minority party is struggling for fiscal relevance, even survival, while the majority party seems bent on crushing it. Post-cliff #1 the climate in Washington remains more warlike than conducive to meaningful compromise and peace.

But amidst the din of political conflict and stalemate two leaders found a way to divert us from the closest cliff. We hope they will be joined by others in the coming weeks who share the same spirit of progress than under the threat of the greater evils.

Impact of the Act on individuals 

The following summary is developed from information provided by Parker Poe Adams & Bernstein LLP, and Bloomberg.

For single filers with an annual income under $400,000, heads of household with an annual income under $425,000 and married couples filing jointly with an annual income under $450,000 (or $225,000 for each married spouse filing separately):

• Marginal rates remain the same as 2012.
• Capital gains and dividend taxes remain the same as 2012 (i.e., 0% for taxpayers in the 10% and 15% brackets; 15% for taxpayers in the 25%, 28%, 33% and 35% brackets). Additionally, qualified dividends for all taxpayers remain taxed at the capital gains rate.
• The employee’s portion of the social security tax rises back to 6.25 from 4.2%.
• Itemized deductions and personal exemptions are phased out for single filers with an annual income over $250,000, heads of household with an annual income over $275,000 and married couples filing jointly with an annual income over $300,000.
• Implements the AMT patch, which indexes for inflation the exemption amount for the alternative minimum tax. For 2012, these exemption amounts are $50,600 for single filers and $78,750 for married couples filing jointly.
• Extends through December 31, 2013 other individual tax provisions that previously expired on December 31, 2011, including those applicable to (i) contributions of capital gain real property for conservation purposes; and (ii) tax-free distributions (up to $100,000) from individual retirement accounts to qualifying public charities.

For  filers whose income exceeds those level above, the top bracket increases from 35% to 39.6%. Capital gains and dividend tax rates increase from 15% to 20%.

Impact on businesses

• The research and development credit is extended.
• The new markets tax credit is extended.
• The increased Section 179 expense deduction of $500,000 is extended with an increased $2,000,000 investment limit.
• 50% bonus depreciation under Section 168(k).
• The Subpart F exception for active financing income under Section 953(e).
• 100% exclusion of gain on the sale of certain small business stock under Section 1202.
• Reduction in the S-corporation recognition period for built-in gains under Section 1374(d).
• Several energy tax credits through December 31, 2013.

Impact on estates

• Increases the maximum tax rate from 35% to 40%.
• Extends the applicable exclusion amount of $5,000,000 (indexed for inflation beginning in tax year 2012), which applies to decedent’s estates, GST transfers and gifts. For 2013, the applicable exclusion amount is $5,250,000.
• Makes permanent the ability of a surviving spouse to elect to increase their applicable exclusion amount by an amount equal to their deceased spouse’s unused exclusion amount, often referred to as “portability.

Retirement savers can reap some benefits from the new tax law as well. The Act allows  401(k) participants to convert any money in their tax-deferred accounts to a Roth 401(k) account, if their employer offers one. These funds may later be withdrawn tax-free in retirement. The change is projected to raise $12.2 billion in revenue over 10 years, according to the Joint Committee on Taxation. It is designed by lawmakers to help defray the cost of delaying spending cuts that had been set to take effect this month, according to Bloomberg.

Impact on the economy

Uncertainty continues in large part for corporations and for individuals as there is much talk of tax reform (translated more taxes), the looming $16 trillion plus debt ceiling negotiations. Republicans, particularly conservative Republicans believe they have yielded more than enough and are now ready to do battle of spending cuts.

Because the issue was on taxes during the last battle, we heard little from Democrats on their willingness to negotiate spending and entitlement cuts. But what we have heard indicates the coming battle will eclipse the one we experienced in the waning days of 2012 with only the Republicans taking fire. This one promises to be political drama at its best/worst as the nation’s creditworthiness may well be on the line.

Through it all the economy and stock market are holding their own. Housing’s fresh resurgence comes just in time to support the flagging manufacturing sector flat jobs outlook. This week’s ISM and Construction Spending reports each showed their respective sectors to be a bit weaker than earlier expected. Alternatively Markit Economics’ PMI manufacturing report continued a relatively strong showing.

Motor vehicle sales for domestics and imports were strong in December, supported in part by replacement sales form Hurricane Sandy. Chain store sales were more mixed due to a slow start which prompted early mark-downs. Sales were strong while profits were pressured.

Significant foundational strength is building on the housing front. US home sales and prices are poised to rise in 2013, according to economists polled by Bloomberg. They are rising from the deepest slump since the Great Depression. Record-low mortgage rates and prices that are a steal compared to five and ten years ago are beginning to spark demand that has been pent-up for a decade.

To many, the economy seems like a compressed spring, ready to explode under the right circumstances. Increased policy certainty as to taxes and regulations would help get the economy firing on all cylinders and contributing mightily to the deficits.

But entirely too many in our government are determined to leave it there. It is not clear whether they don’t understand the math that taxes, even at 100%, do not come close to addressing the problem of continued deficits, or if ideology completely trumps the consequences of allowing entitlements to continue unabated, or if their own political survival is more important than the survival of the nation. We all hope enough will have the courage to compromise and to act responsibly beyond the next two, four, and six years. Peace.