15 Nov 2012 Muhlenkamp Market Commentary - Post-Election Impact ( Portfolio ) The U.S. national election is over. Some of the uncertainty around taxes and regulations is now clarified. We’re likely to get more of each. Attention has shifted to the “fiscal cliff.” Much has been written and commented about the big picture, let’s examine the impact to wage earners and retirees.
As the U.S. tax code is currently written, several changes will take place on January 1, 2013:
1. The payroll “tax holiday” ends, so automatic deductions for FICA (Social Security) taxes will increase by 2% of gross pay for nearly all wage earners.
2. The Bush-era tax rate cuts will expire. We’ve heard that the Bush-era tax rate cuts were for the “rich,” but, in fact, the rates were cut on the order of 3% for nearly everybody. (Refer to the following table for details.)
A Comparison of 2013 Income Tax Brackets
Married Filing Jointly
Taxable Income Bush Tax Cuts In Place Bush Tax Cuts Expired
(tax rate) (tax rate)
$0 - $17,800 10% 15%
$17,800 - $60,350 15% 15%
$60,350 - $72,300 15% 28%
$72,300 - $145,900 25% 28%
$145,900 - $222,300 28% 31%
$222,300- $397,000 33% 36%
$397,000 - 35% 39.6%
Source: Joint Committee on Taxation
Bottom line: For the average wage earner, expiration of the above will raise taxes paid by roughly $2,000 - $3,000 per year.
3. The tax on dividends will go from 15% to the individual’s (couple’s) rate on ordinary income.
4. The tax on capital gains will go from 15% to 20%, plus a 3.8% surcharge for high-income tax payers.
5. The inheritance tax will go from 35% with a $5 million exemption, to 55% with a $1 million exemption.
Consumers, business owners, and investors all focus on after-tax dollars; after all, it’s the only money you can spend or invest.
So the above changes are likely to have the following consequences:
Taxpayers will have less money to spend. If you take a look at your current paycheck and subtract 5%, you’ll get some sense of what your paycheck will look like after January 1. If you recall that the 2009 recession resulted from consumers cutting back on spending (voluntarily) by 5%, you’ll get an appreciation for what may happen when their incomes drop by 5% due to increased taxes
Dividends will be worth less than before. Consequently, stocks will be worth less than before. As the Federal Reserve has concentrated on driving interest rates lower over the past three years, retirees and other people with savings have gone further and further afield trying to find useful “incomes.” We were recently told of a search for “creative sources of yield,” which implies that the search continues, but is running short of ideas…usually a very bad sign.
The higher tax rates on capital gains are likely to result in a rush to realize capital gains through the sale of stocks or businesses before 12/31/12. Those not selling before this date, then, are more likely to allow the tax to be deferred by postponing the realization of capital gains (through the sale of assets) in the future.
Many small business owners pay company taxes at their rate as individuals. With more money going to taxes, they will have less money to pay in wages. When faced with a higher tax bill and more regulation, a greater number of small business owners will choose to retire earlier than planned.
Over the years, we’ve observed that when tax rates exceed 45%-50%, people do strange things with their money to avoid the tax. Remember the tax schemes of the 1970s? Federal income taxes are not currently scheduled to exceed 45%, but estate taxes are. It will be interesting to see what results.
The window for these tax changes to be delayed or further modified is now less than 50 days. This means the decision timeframe for investors to change their actions to adjust for the increased likelihood of higher taxes is closing. (Until November 6, many decision makers waited for the election results, knowing they had 60 days to implement changes after the election.)