Legislation to avert the fiscal cliff passed both chambers of Congress yesterday.  President Obama is expected to sign it into law today.

In short, the bill lets a variety of taxes increase for wealthy Americans, averts most middle class tax hikes and leaves entitlement programs untouched. Although all of the details of the legislation are difficult to come by at the present time, here is a rundown of some of the more salient points.

The bill permanently extends existing tax rates on incomes under $400,000 for individuals and $450,000 for joint filers.  Some commentators are reporting that it is unclear from the bill whether those income levels refer to adjusted gross income or taxable income.  It probably means adjusted gross income.  Tax rates on incomes above that level rise by 4.6 percentage points to 39.6 percent.  Taxes on capital gains and dividend income for those upper incomes will rise from 15 to 20 percent.  Health care reform also will levy a new surtax of 3.8 percent on capital gains and dividend income for those upper incomes pushing their capital gains rate to 23.8 percent.

There is a permanent fix to the alternative minimum tax, which will protect many middle class Americans from higher rates.  Personal exemptions and itemized deductions for individuals earning $250,000 and couples earning $300,000 will be limited.  These rules are meant to reduce or eliminate the value of personal exemptions and itemized deductions for taxpayers earning more than the income thresholds.  The federal estate tax exemption amount remains at $5 million and is indexed for inflation going forward; however, the estate tax rate rises from 35 to 40 percent.

The bill extends tax credits for parents raising children and those who are paying for a child’s college tuition.  The deal lets the Social Security payroll tax rise by 2 percent in 2013, which will cost a taxpayer earning $50,000 a year approximately $1,000.

The package extends emergency unemployment compensation through 2013, preventing some 2 million jobless people from losing their benefits.  A 27 percent pay cut to physicians under Medicare is averted for one year and offset by cutting reimbursements to other health care providers.  Automatic cuts to defense and domestic spending are postponed for two months and there are no cuts to Social Security, Medicare or Medicaid.

Our Thoughts

We understood that for a deal to get done there would have to be compromise on both sides of the aisle.  And, compromise necessarily entails both   good and bad for each side.  Yes, we like the idea of certainty in the tax code and the fact that taxes don’t go up for a majority of people.  However, this bill does nothing to address spending cuts and, consequently, we believe it is not balanced.  Many Republicans are upset by this vote because they believed it did not do enough on the spending side.  Keep in mind, Republicans won the House in 2010 on a platform of reduced spending.  We have been saying for years that spending is our problem, not revenue.  According to estimates, this plan will raise roughly $600 billion in taxes over 10 years.  However, the Congressional Budget Office projects the plan to generate a $329 billion increase in our deficit in 2013 and a $3.9 trillion increase over 10 years.  It was our understanding that any deal was supposed to reduce our deficit, not increase it.  The bill adds $41 in tax increases for every $1 in spending cuts – that is not balance.

The bill also “kicks the can down the road” again.  Part II is coming in a few weeks as discussions on the debt ceiling – which has already been breached – and the sequestered spending cuts – which were delayed until the beginning of March – will take place.  If one expects there to be balance in our efforts to reduce our deficit, then one would expect these discussions to focus on spending cuts.  After last night’s House vote, Obama said that wealthy corporations and individuals will be expected to pay more in order to fix our deficit “in a balanced way.”  Given all of this, the Part II debate may make the fiscal cliff debate look like a walk in the park.

In the short-term, the market has reacted positively (returning to its price level on December 18th) to the fiscal cliff deal.  In the long run, stocks could react negatively as a result of a drop in economic activity from the higher taxes on both individuals and corporations.  The best solution to Part II negotiations is a deal that contains significant spending cuts and deficit reduction.  As these negotiations progress over the course of the next couple of months, we expect the market to be volatile.

Sincerely,

Your THOR Team