Taxageddon – 7 Trillion USD Fiscal Cliff heads towards us

While we are all – cautiously – looking at the US, European and Chinese economy, hoping for some improvement or at least not a set-back too big, a 7 Trillion USD Fiscal Cliff is heading towards us. 7 TRILLION – I do not even know how to abbreviate Trillion. 2.3 Trillion USD of spending cuts and 5 Trillion USD tax hikes will hit the US economy by 1st of January, 2013. It’s still not a given fact, but has some probability. And even if Republicans and Democrats can find a way to kick the can down the road, the nitty-gritty discussions leading to that hoped-for outcome will impact markets and economy. But what’s going to happen?

I) 2013 fiscal year starts in October 1st, 2012. By that time the US government should have a budget in place. It will not. Given the timeline for the presidential elections (November, 6th), this will simply not happen. Well- nothing to worry about: there was no US-budget since years. Sarcasm aside: how can the leading industrial nation not have a budget since years? This is no banana-republic. How can this not be a major discussion point in the elections campaigns? How can all this discussions not drag down US economy and markets? Unless thinking about a major diversion (Iran?) I cannot see, how it cannot.

II) By October or November the US debt ceiling is going to be leveled out. Maybe you can remember the discussion in August 2011 about raising the limit. Without such an agreement to raise the limit, US government has either to send employees home, close its national parks, stop payments for retirees or stop payments on its debt. Last time, the discussion went quite unnoticed, as the Europeans have been fighting their debt crisis. This time, presidential elections on November 6th and hitting the tax limit will interfere with each other – and there is maybe no European diversion. How this can-not happen to lead to nasty discussions of politicians, impacting the economy and the markets?

III) By 1st of January, 2013 the Bush tax cuts will no longer apply, the social security tax hikes will hit, and the spending cuts will hammer in. Those are the details:

- Social Security payroll tax will raise from 4.2 to 6.2 percent of income - 124 USD bn effect on tax payers - will cost the average family a 100 USD a month
- Alternative Minimum Tax (AMT) expires -118 USD bn effect: AMT means that you cannot press your tax rate below a certain level (the alternative minimum tax) by different tax deductions. This regulation was not applied since the Bush tax cuts for certain (lower) income groups, but will be effective again.

- Income tax or to be more specific the marginal tax rates will increase. The rate for the first USD 8,700 will increase from 10 to 15 %, the top rates will go from 33 to 36 % and from 35 to 39.6 %
- Itemized deductions (like housing interest, charity donations, …) will no longer be considered at your marginal tax rate, but at a maximum of 28 % (average tax effect of +1.2 % on the US tax payer)

- Assuming Obama’s health care reform makes it through Supreme Court, a +0,9 % Medicare Hospital Insurance tax (HI) will apply for incomes above USD 200.000 (or USD 250.000 filing jointly) (increasing the tax from 2.9 to 3.8 percent)
- The top Capital Gains tax will increase from 15 to 20 % (for long-term capital gains with above one year holding)
- Dividends will no longer be taxed as capital gains (10 – 15 %), but at marginal income tax rate up to a maximum of 39.6 %
- Additional 3.8 % Medicare tax on unearned income (interest, dividends, capital gains, annuities, royalties, rents) will be effective, with the same thresholds applying as for HI-tax. The effect will be USD 20 bn,

- The marriage penalty for joint filers comes back
- Child credit per child drops from USD 1.000 to USD 500 – this will no longer be refundable generally, but on more limited conditions (only with 3 or more childs, … ).

- The estate tax rate goes from 35 % to 55 % (tax on the taxable estate of a deceased person), tax exemption drops from 5 mn USD to 1 mn USD.

Some of these increases will hit every tax payer in the US. Some only if you earn 200.000 USD or more. Currently, 4 % of Americans earn more than 200.000 USD (according to IRS). Fewer than 1% currently pay the 35% income tax rate and fewer than 4% even pay 33%. As for the old 39.6% rate: Adjusted for inflation, you'd only pay that now on any income over $363,000 a year – but the limits are not raised, they are just in effect again. Take a married couple earning a 125.000 USD (less than 100.000 EUR) a year before taxes – their income tax will go from 19.400 to 23.400 USD and taking social security taxes into consideration, they will lose roughly 500 USD a month.

IV) This all still does not address US government spending, having increased 1 Trillion USD over the last year and running deficits every year.

V) In order to raise the deficit limit in 2011, there was agreed on automatic spending cuts in 2013, after all the elections did take place. The Budget Control Act was put into place, cutting the budget by 2.1 trillion USD between 2012 and 2021 (or: a tenth of that sum every year). 900 billion of that have been included, named, itemized or whatever you want to call it in the Act. 50 % or 450 USD mn should come from defense, and another 50 % from non-defense – excluding Medicaid, food stamps, Social Security and other benefit programs. The rest – 1.2 trillion USD – where not even allocated generally to any field of politics, but should come out of the decisions of a so-called Super-Committee, consisting of 6 Republicans and 6 Democrats.

VI) So far we have no decisions from the Super-Committee, nor from Congress, on additional spending cuts. There simply is no sound plan how to stay within the limits, how to go on further.

So now you tell me, how all that should not affect the US economy and thus the world economy!

At the moment, the markets seem to ignore it. A 7 Trillion USD impact is so huge, so insane - even B52 Ben Bernanke seems to be frightened. “And I am concerned that if all the tax increases and all the spending cuts that are associated with the current law which would take place, absent any Congressional action, that would occur on January 1st that that would be a significant risk to the recovery. So I am looking and hoping that Congress will take actions that will address both sides of that ‘uh’ both requirements of good fiscal policy.”

Markets seem to ignore this event, saying: it will not happen. Let us hope, it does not. But even if it does not, there will be blood down the streets before politicians get their act together. I don’t see, how all this cannot effect the next 6 to 12 months.