Fixed-income portfolio manager Wesley Phoa and tax analyst Elizabeth Mooney discuss the recent deal reached by Congress to avoid going over the fiscal cliff. The agreement calls for some taxes to increase, while allowing others to remain at prevailing levels. It also delays the automatic spending cuts for two months, presenting a muddled picture for the economy and markets during that period. Lawmakers also still need to address many longer-term fiscal issues related to entitlement spending and tax reform.

What are your initial impressions of the last-minute deal that Congress reached to avoid going over the fiscal cliff? Were there any surprises as to what was included or left out of the legislation?  

Wesley: Six weeks ago, the most likely scenario seemed to be just a short-term extension of the status quo, with some fiscal drag. That is in fact what happened, but with two important differences. First, most of the Bush-era tax cuts have been extended permanently, though higher rates will be put back in place for high-income households. In that sense the deal is better than the short-term extension scenario, because it has locked in some certainty about individual income tax rates rather than having this come up again in six or 12 months.

Second, the sequestration cuts have been delayed for only two months, an outcome that is a bit more unsatisfactory than the short-term extension I envisioned six weeks ago. The delay means that the spending cuts will be addressed at around the same time as the debt ceiling, which I think is deliberate. Congress and the President will have to spend the next two months continuing to negotiate with each other, trying to reach another deal to address these open issues.

Elizabeth: The biggest surprise to me was the two-month delay in the spending cuts. It was most likely moved to coincide with the debt ceiling debate, which has major consequences. The Republicans are betting that President Obama will do almost anything to raise the debt ceiling. Their negotiating leverage will be that they will not vote for it without major spending cuts in place. It sets up a dynamic much like we saw in the 2011 debt ceiling debate. I was also surprised that the alternative minimum tax patch, which indexes the AMT for inflation, was made permanent.

What is the impact of the fiscal cliff deal on taxes, and what effect will the new rates have on consumers and investors?

Elizabeth: The new tax rate of 20% on dividends and capital gains is better than many expected. It is a lot lower than the top marginal income tax rate of 39.6%, which would have been the dividend tax rate had they not agreed to increase it from 15% to 20%. It is hard for me to see that small of an increase having a major impact on investors. The estate tax only going up a small amount was not a big surprise but a relief to many high-net-worth investors.

There is no question that middle- and low-income households are net winners in this deal. I was a bit surprised by the threshold being $400,000 in taxable income for individuals and $450,000 for couples; for a long time they talked about it being lower. The net losers are high-income households, which will be paying more in taxes. But in terms of economic impact, their spending tends to be less sensitive to tax increases than that of low- and middle-income taxpayers.

As for the impact on consumer spending, I think we avoided a big hit. The expiration of the payroll tax holiday will hurt to an extent, but the economy can absorb it. An offset is the AMT patch, which was made permanent to help many middle-income households. Another positive is that consumers will have greater certainty on their tax outlook now that the deal is done.

Do you believe this deal is enough to get future negotiations headed in the right direction, given how much remains to be done? What are the most pressing issues still on the table?

Wesley: The Democrats wanted tax rates on high-income individuals to increase — that was a clear commitment that President Obama made during the campaign — and they got that. The other thing they wanted and were able to get was a temporary extension of certain provisions that they thought were important, such as unemployment insurance and parts of the 2009 stimulus act. But the Democrats did not get everything that they wanted, such as an extended payroll tax holiday. They also gave up the leverage of having the Bush tax cuts expiring at some point in the future. On the other hand, the Republicans permanently locked in virtually all of the Bush tax cuts from 2001 to 2003. They conceded higher tax rates on some high-income individuals. They also preserved their leverage to impose future spending cuts and outlays by retaining the debt ceiling as a weapon. There was some hope on the Democratic side that the debt ceiling issue could be addressed permanently as part of the fiscal cliff negotiations.

The first thing Congress has to do now is decide on discretionary spending cuts. It is important to remember that the Budget Control Act of 2011 always anticipated discretionary spending cuts that were to be roughly equal in size to the automatic cuts imposed by sequestration. The problem with sequestration is that the cuts are inflexible and highly inefficient. Over the next couple of months, we should expect to see more intelligent discussion about smarter spending cuts, but it is going to be extremely difficult because Congress decided to impose this very tight time frame. It is unlikely that they will be able to work out all the details on the discretionary spending cuts within two months, so there will be some decisions that have to be deferred until later.

 The second big issue they have to deal with is entitlement reform, which mostly involves Medicare and Social Security. There were a number of cuts to Medicare proposed in the original grand bargain that President Obama and Speaker Boehner nearly agreed to. For Social Security, one of the major proposals was to move to a chained consumer price index for cost-of-living adjustments, which would save a substantial amount of money over time. (Unlike core CPI, this inflation index takes into account the fact that consumers’ buying patterns respond to changes in the relative price of goods and services.) During the negotiations in December, Senate Republicans at one point wanted to include chained CPI as part of the short-term fiscal cliff deal. Democrats rejected that because it involves a permanent change to the structure of Social Security, which in their view should only be introduced as part of a comprehensive long-term fiscal agreement rather than a short-term negotiation. That strategy makes sense, and it is very likely that the chained CPI idea will come up again. The Obama administration has already indicated that it is open to the idea, so it will likely be implemented. Note that a move to chained CPI would increase tax revenues as well as reduce outlays, if it were used to index tax thresholds.

How optimistic are you that some sort of comprehensive deal will be reached to reform the nation’s tax code?

Elizabeth: The deficit is a huge economic problem, and the current debate foreshadows years and years of difficult lawmaking in small steps. I cannot imagine a scenario in the near term in which we get comprehensive tax reform that will impact long-term deficit reduction. It is going to take many years of smaller deals — raising taxes and cutting spending. I don’t know how much longer we can kick the can down the road, but I cannot imagine our government agreeing on major reforms at this point. Maybe they will significantly cut government spending, which will also likely have serious economic consequences. Republicans will push for spending cuts in exchange for voting to raise the debt ceiling in February. But it will be difficult to significantly improve the deficit unless Congress really cuts hard into Medicare and Social Security. If they are going to make a dent in the problem, lawmakers have to reduce spending on those large entitlement programs.

Beyond that, corporate tax increases are all that’s left, assuming Congress won’t raise taxes significantly on individuals beyond what it just did. The major areas to broaden the tax base for corporate income include reducing the corporate debt interest deductibility and deferring depreciation deductions. Other smaller areas for raising revenues include eliminating tax benefits made available to oil and gas companies, reducing the dividends received deduction, and reducing the deductibility of stock compensation. I expect that we will see a tightening of the screws on profits moving offshore. It is unlikely that there will be significant tax increases on master limited partnerships and real estate investment trusts, in part because earned income is taxed at individual tax rates, which just increased under the new law.

Moving to a territorial system for corporations and requiring repatriation to tax accumulated undistributed foreign earnings is unthinkable without a corporate rate reduction. At this point, I don’t see politically how Congress could reduce the corporate tax rate in the wake of increases in individual tax rates and impending entitlement spending cuts hitting individuals.

Wesley: There have been many people on both sides of the aisle in Washington working on ideas to reform the tax code. Obviously, it didn’t happen last year and it was never realistic to expect that it would. I think what we’re going to see is a succession of partial deals, where more and more issues are permanently sorted out, as happened in this most recent agreement. It would be more optimal for Congress to sort everything out all at once, but the benefit of carrying out reform in this more protracted way is that both parties are more likely to stick with it because it was such a struggle. Reform is more credible after both sides have had to fight to exhaustion for a result. That makes it more likely the next administration or Congress will not just turn around and reverse it.

Given that some taxes will increase and spending will likely be cut soon, are you still concerned about the impact of the deal on the economy?

Wesley: In my view, the deal has greatly diminished the chance of a near-term recession, which was highly likely if no agreement had been reached. Nevertheless, it has come at the cost of increasing the deficit by around $4 trillion over 10 years relative to what it would have been had we gone over the fiscal cliff.

The economy will still experience some fiscal drag this year, mainly from three different sources. First, the payroll tax holiday expired, which we should have expected as it was always meant to be a temporary stimulus. In fact, had it been left in place permanently, Social Security would be in significant trouble. Second, taxes increased on higher income individuals and households. The third source of fiscal drag, which was never really part of the fiscal cliff negotiations, is the new 3.8% investment income surtax on high-income households as mandated by the Affordable Care Act. Those three things add up to a fiscal drag of about 1% of GDP, in my estimate.

There is a lot of dispute about what kind of multiplier effect fiscal policy has, but however you cut it, a fiscal drag of about 1% of GDP is not enough to push us into a recession in 2013. My own estimate is that, allowing for no fiscal drag whatsoever, the momentum that the recovery has built — particularly with the tailwinds from housing and autos — would have been consistent with GDP growth of about 3.5% to 4% in 2013. With a fiscal drag of 1%, then I would expect 2.5% to 3% growth. That growth rate should bring about a gradual decline in unemployment. It is also consistent with some rise in core inflation. While there is still substantial slack in the economy, we could see some supply bottlenecks emerge in the context of that growth rate.

Looking at the rally in the stock market after the deal was reached, do you think the reaction by investors was warranted, or does it raise concerns about valuation levels?

Wesley: The reaction seems quite rational. Not reaching a deal would have meant a recession, and in that case it would have been very unusual for the stock market not to sell off at least 10%. Now we are almost certain not to have a recession this year, so a rally of 4% to 5% in equity markets appears logical. I think that what happens to markets over the next two or three months will continue to be driven a lot more by the dynamics in Washington than anything else.

In the bond market, my base case is pretty consistent with Treasury yields going up, but only moderately because the Federal Reserve is trying to keep long-term interest rates steady. Inflation-linked bonds and corporate bonds are also likely to continue doing relatively well. By building in the short-term debt ceiling issue, Congress has almost guaranteed that we’ll have a bumpy ride, so there will likely still be considerable demand to own both Treasuries and other high-grade bonds as insurance. In the near term, I would not expect to see any kind of massive asset allocation shift out of fixed income into equities.

The statements expressed herein are current as of January 2013 and are subject to change at any time based on market or other conditions. They reflect the views of an individual and may not reflect the views of other investment professionals in our organization. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with your Investment Counselor. © 2013 Capital Group Private Client Services. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited.