Potential Tax Hikes Come Into Focus After Obama's Win

Investor's Business Daily

Until President Obama's victory Tuesday, going over the fiscal cliff seemed like a distant possibility.

Reality may have begun to set in on Wednesday. Unless Obama yields, at least for now, on a central campaign plank — that taxes rise for higher earners — the Republican-led House will have little to gain by striking a deal before the tax cliff hits.

If tax hikes come to be seen as hurting the economy, the Republicans won't want to share responsibility.

The U.S. "may at least briefly go off the fiscal cliff at the end of the year," IHS Global Insight wrote. "This would be a recipe for turmoil in the financial markets, and would threaten such a severe shock to the economy that the pressure to come to some sort of compromise would be extreme.

Come Jan. 1, a series of tax hikes would take effect totaling $400 billion through the end of fiscal 2013 — just nine months.

On top of that, automatic spending cuts would kick in on Jan. 2, divided between the Pentagon and domestic programs. Extended jobless benefits would lapse and Medicare would slash payments to physicians.

Over the full year, the combined tax hike and spending cut would be at least 4% of GDP.

Both parties are committed to avoiding a hard fiscal landing, and they'll likely do so. But that doesn't ensure it will be a smooth ride, and there could be a price to pay in terms of economic growth.

Major stock market gauges tumbled Wednesday as Obama's re-election focused attention on this near-term flashpoint and the likelihood of higher taxes — especially on investment income.

In the wake of the election, Goldman Sachs cut its 2013 economic growth forecast by 0.2 percentage points, citing prior signals Obama would veto an extension of the Bush tax cuts for households earning $250,000.

That would mean the top income-tax rate rising to 39.6% from 35% and the long-term capital gains rate rising to 20% from 15%. Taxes on dividends would jump from 15% to 39.6%.

Together, these changes would raise tax revenue by $56 billion in 2013, Goldman said.

The election's clearest impact is the survival of ObamaCare, along with its related tax hikes that make up another part of the fiscal cliff and will raise about $25 billion next year. Including ObamaCare's 3.8% tax on non-wage income, the top capital gains rate would rise to 23.8%.

Goldman Sachs equity strategist David Kostin noted recently that such a tax change "could drive year-end tax selling, based on previous history.

The two prior times capital gains taxes rose by comparable amounts, in 1970 and 1987, the stock market fell in December by 1.9% and 2.8%, respectively.

With the jobless rate still near 8% and business investment flagging, the economic case for an immediate tax increase is weak.

House Speaker John Boehner struck a bipartisan tone Wednesday, saying that his party could agree to raise revenue "under the right conditions.

But his conditions — a pro-growth reform of the tax code that lowers rates while narrowing tax preferences — can't be met before the cliff hits.

While Obama listed tax reform among his second-term priorities in his victory speech, a tax code overhaul would drag well into 2013.

The question facing the White House is whether to flirt with the fiscal cliff by insisting on higher taxes immediately or to hold off for now to keep the economy from weakening and in hope of encouraging GOP cooperation.

The fiscal cliff is really an artificial deadline, but there is a real deadline looming six months or so after that.

Fitch Ratings has said that a failure of Congress to agree on major deficit reduction in the first half of 2013 could lead it to knock the U.S. credit rating a peg from AAA. Moody's, likewise, has set 2013 as the last chance for Washington to save its top rating. S&P, which cut the U.S. in August 2011, has threatened a further cut.

While government borrowing costs actually fell following S&P's historic downgrade, action by multiple agencies could have more of an impact.

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