Let’s Discuss: Year-End Expiration of Tax Cuts

by Bryan Perry | May 17, 2012 11:00 am

The current pullback in the major averages is primarily a byproduct of the turmoil surrounding political events in Europe and the uncertain course that the eurozone will take to address its ongoing fiscal crisis. Here in America, we can’t fix that problem, but our markets are retrenching just the same — albeit in a more orderly fashion.

The most recent spate of softer-than-expected domestic data is likely to prompt the Fed to consider another round of quantitative easing when the Fed meets in June. If so, that course of action very likely will put a floor under U.S. equity markets. PIMCO’s Bill Gross, the biggest bond manager in the world, is forecasting that the Fed will keep on stimulating after Operation Twist expires in June. If that happens, it should be welcome news to the market, as investors are starting to anticipate this policy.

What isn’t welcome news is the topic of what happens if the Bush tax cuts simply expire at the end of 2012. Essentially, everyone’s federal income and investment tax rates will go back up to where they were before the 2001 tax cuts were passed. In other words, your tax bill next year would increase. If the tax cuts do expire and tax rates go up, you may notice the difference in your wallet as early as January, when your employer starts to withhold more taxes from your paycheck.

The Tax Policy Center estimates that a married couple with two children under 13 and a household income of roughly $75,000 could end up paying about $2,600 more in federal income taxes next year than they would if the tax cuts were extended. However, the likelihood of all the tax cuts expiring isn’t high: Both Democrats and Republicans agree that they want to extend the tax cuts at least for folks making less than $200,000 ($250,000 for joint filers).

For those households making more than the $200,000/$250,000 threshold, marginal income taxes would climb between 3% and 4%, along with the elimination of the qualified dividend rate of 15% and a rise in the capital gains rate by at least 5% — and probably more like 7% to 22% — with stock sales under a one-year time frame subject to ordinary income tax.

Given the backdrop of a slower pace of growth, a cautious Fed chairman and a spiraling deficit that must be addressed, I expect some form of higher taxes to be a part of our future. I just don’t see any other way around it from a congressional standpoint, even if Republican Mitt Romney does win. The shared sacrifice of higher taxes and lower spending will drive the dialogue, with maybe a cut in corporate tax rates to spur hiring. It would seem that this would be the course of least resistance and everyone would save face with their constituencies. The upwardly mobile would pay more, and we’d start to get our fiscal house in order.

Whether the Bush tax cuts expire or President Obama’s budget is passed, they’ll have the same effect on wage earners. Either way, it’s my view that there will be strong rotation into tax-free and tax-deferred investments. Once investors who are still in the workforce max out their pension contributions, they — and others with disposable income — likely will seek to increase their holdings in municipal bonds and master limited partnerships (MLPs).

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