Fiscal Cliff EV Sept 12

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Eaton Vance on Washington

Andrew H. Friedman

Principal

The Washington Update

Not FDIC Insured Not Bank Guaranteed May Lose Value

In recent months, a new phrase has entered the

national lexicon, a phrase that is likely to reverberatewith increasing intensity in the months ahead. That

abrupt slowdown in the economy that could occur in2013 if taxes rise and government spending falls ascurrently scheduled.

Among them are:

Expiration of the Bush tax cuts

The Bush tax cutsthe lower tax rates in effectfor the past decadeare scheduled to expire atthe end of 2012. Republicans believe the Bush

tax cuts should be extended for all taxpayers.Democrats believe they should be extended onlyfor middle and lower income families. PresidentObama has said he will vetoany further extensionof the Bush tax cuts for upper income families.

Expiration of the payroll tax cut

In 2010, to secure the Presidents assent to a

two-year extension of the Bush tax cuts, theRepublicans agreed to reduce the employeeSocial Security tax rate in 2011 from 6.2% to4.2%. Subsequently, the Republicans grudginglyagreed to extend this lower Social Security tax

rate through 2012 as well. Perhaps surprisingly,Congressional Republicans did not require thatthis extension be paid for (offset with taxincreases or spending cuts elsewhere).

Another extension of the payroll tax cut is

unlikely. The President believes the loweremployment tax rate puts money in workerspockets, which they will spend and help revivethe economy. But many Republicans are

not believe that allowing workers to retain a smalladditional portion of their paychecks actuallygrows the economy. Many legislators also believethat it is not good policy to deplete the fundsavailable for the Social Security program.

New health care reform taxes

To help finance the health care reform law,

Congress approved a new tax on investmentincome to take effect in 2013. Beginning nextyear, to the extent a familys overall incomeis above $250,000 ($200,000 for individualtaxpayers), taxable investment incomee.g.,interest, dividends, capital gains, rents,royaltieswill be subject to an additional tax of3.8%. This additional tax will not apply to non-taxable income such as tax-exempt municipalbond interest, or to amounts withdrawn from

Unless the Supreme Court strikes down the entirehealth care reform law as unconstitutional, the

additional tax on investment income will takeeffect in 2013, as the Democrats are unlikely toaccept any change to their signature legislation.

What is the Fiscal Cliff?

Legislative Update August 2012


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Eaton Vance on Washington August 2012 2


Spending cutsThe compromise reached last August to increasethe national debt ceiling (thereby allowing theUnited States to avoid defaulting on Treasurysecurities) calls for cuts in discretionarygovernment spending of $2.1 trillion over tenyears, including about $1 trillion of defensecuts. The bulk of these cuts are slated to beginin 2013.

Republicans now assert that the compromise

implement cuts in excess of the agreed-uponamounts. At the same time, they want to reducethe portion of the cuts allocated to defense.Congressional Democrats have made clearthey will not support cuts to social programsabove those enumerated in the compromise.The President has said he will veto any effortto unwind the spending cut agreement reachedlast August.

Congress need not pass a single piece of tax

legislation in 2012 for the tax increases and

spending cuts outlined above to take effect in 2013.

They will happen by default.

If Congress fails to stop the implementation of theseprovisions, the higher taxes and lower spending

economy in 2013. Economists differ in theirestimates, but many expect the slowdown to bearound a 3.5 percentage point reduction in GDP.See, e.g., U.S. Fiscal Cliff Notes, J.P. Morgan (April26, 2012). With GDP currently growing at less than

throw the economy back into recession for at least

week by a report from the impartial CongressionalEconomic Effects of Reducing the

Fiscal Restraint That Is Scheduled to Occur in2013

In the current tumultuous campaign environment,

legislation before Election Day. Thus, the fate of thetax increases and spending cuts will be decided,if at all, by a lame duck Congress conveningbetween Thanksgiving and Christmas in 2012. TheCongress that returns for that session will be theexisting Congressa Republican-led House andDemocratic-led Senateregardless of the election

at the end of 2012: either he will have been re-electedfeeling newly-empowered to enact hispoliciesor he will be a lame-duck president who

can do what he believes is right without concern forthe consequences.

The hope is that, standing on the edge of the fiscalcliff, the parties will negotiate a compromise duringthe lame duck session. The most likely candidatefor compromise is the pending expiration of theBush tax cuts. The Republicans have suggested acompromise that would extend all the tax cuts forone more year to give Congress the opportunity toenact tax reform in 2013. Tax reformloweringtax rates, eliminating loopholes, simplifying the taxcode, eliminating the AMTis universally popular

The Democrats almost certainly would insist thatany agreement designate a trigger to take effect ifCongress fails to agree on tax reform next year. Themost likely trigger would be the expiration of theBush tax cuts for all but middle- and lower-incomefamilies. The Republicans are unlikely to accept sucha trigger; they refused to allow a tax increase as thetrigger if (as subsequently happened) the SuperCommittee failed to agree on spending cuts in thewake of the August budget compromise last year.


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Eaton Vance on Washington August 2012 3

A more obvious compromise is to extend the tax

past the President has insisted on ending the cutsfor families with income over $250,000. However,his recent insistence on the Buffett rulewhichwould require families with income over $1 millionto pay tax at a rate no lower than the rate imposedon the middle classsuggests that he might accepta $1 million threshold for application of the taxincrease. The Republicans will have to swallowhard to accept any tax increase, but if the Presidentmaintains his threat to veto a tax cut extension that

a compromise as preferable to having the tax cutsexpire for everyone next year.

Compromise on the spending cuts is moreproblematic. The Democrats (at least so far) areinsisting on implementing the budget agreementof last August, and the Republicans actually areseeking cuts in addition to those agreed upon.Standard & Poors and Moodys have announcedthat a failure to implement the agreed-upon cutswill result in another downgrade in U.S. debt. ThePresident seems to feel it a point of pride to makesure the compromise takes effect.

Given the rancor that will infuse the campaign,the possibility of a deadlock in the lame ducksession cannot be dismissed. If Congress fails tocompromise and the tax increase and spending cutstake effect, Congress conceivably could roll back thechanges next year. As a practical matter, however,this is likely to happen only if the Republicans winthe White House and both houses of Congress.Even in that case, there are procedural maneuversin the Senate the Democrats might try to avoid ordelay such a roll-back.

likely to remain volatile for the remainder of theyear. Historically, markets have been volatilebefore a national election, but calm down once theelection is over (regardless of who wins) becauseuncertainty is reduced. This year, however, volatilitymay actually increase after the election due touncertainty about whether and how Congress will

Moreover, the threat of rising capital gains tax ratescould prompt investors to sell assets to lock in gainsnear year end, further adding to market volatility.



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discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its

accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding

tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel as to matters

discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.

Copyright Andrew H. Friedman 2012. Reprinted by permission. All rights reserved.

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Fiscal Cliff EV Sept 12