Should You Care About the Fiscal Cliff?

Posted by   admin on    June 21, 2012

Should You Care About the Fiscal Cliff?

Have you been following the controversy over the looming Fiscal Cliff? It's a hot item in the news these days warning that the European Debt Crisis is not as big a threat to the U.S. economy as the Fiscal Cliff we are headed for at year's end. Why do they call it a Fiscal Cliff?

By definition, fiscal policy refers to how the U.S. government determines to assess and collect taxes from us and how they choose to spend the money collected. And a cliff is a high, steep overhanging rock. The average person is likely more familiar with the latter definition as we learn it at a young age and are awed by the height and danger associated with it. The term Fiscal Cliff has nothing to do with showing esteem for the direction of fiscal policy nor that we will be achieving a majestically high policy from where we are able to see over the horizon. Rather it refers to the thinking that the direction of fiscal policy will take our economy plunging over the edge of the cliff.

Despite what is often headline news throughout the media, my experience is that the average person either hasn't paid attention to Fiscal Cliff concerns or doesn't understand why they should. Maybe few realize the implications because it hasn't been spelled out clearly enough. Or, as it is also a presidential election year, perhaps the wit, wisdom and conflicting opinions of politicians have many confused about what it all means.

It's my guess that, by now, the average person realizes the U.S. government is grid-locked by widely divergent ideologies regarding how fiscal policy should shape the nation. It seems that Washington is overrun by Conservatives and Liberals and Moderates are few and far between. As a result, the U.S. government is now running on auto-pilot and the current direction is heading us towards the edge of the cliff - and it will happen soon.

This article takes a closer look at how the Fiscal Cliff will impact many families this year and next. As well, many friends have commented that they thought they were dropped from receiving these articles. Not true, it has been a few months since I penned one  I'll explain later. So, you might not want to miss reading this one.

Tax Law Changes - What's About to Happen to Your Wallet?

During the George W. Bush Presidency, Congress enacted two laws that lowered tax rates across all brackets, lowered rates on qualified dividend income and long-term capital gains, raised the education and child tax credits, raised the threshold for the alternative minimum tax and lowered taxes through a number of other changes.

Commonly referred to as the Bush Tax Cuts, they included provisions that made them expire at the end of 2010. After much debate, with a Democrat majority in the House of Representatives, the Senate and President Obama occupying the White House, the Bush tax cuts were extended for two years as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. Now, with a divided Congress, the Bush Tax Cuts are due to expire at the end of this year and both parties are unable to effect a change in course. Add to this the expiring payroll tax holiday and other tax increases coming from the Patient Protection and Affordable Care Act of 2010 (also known as Obamacare) and we get the three significant shoves to push us over the Cliff.

Up to this point I've only discussed how taxes are about to go up for many families in the U.S., but whats about to happen to your wallet? In the following tables, Ill show you some examples about what you might expect if Congress doesn't act.

In the first example, let's take a look at two households where both spouses are employed and have two school-age children. The first household has total earned income of $100,000 and investment income of $5,600; the second household has total earned income of $200,000 and investment income of $11,200 (twice that of the first). Both households are part of the, so called, 99%.

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In case it isn't apparent, the tax bill for both these households begins to go up in 2012. Thats because of the Alternative Minimum Tax or AMT, for short. The AMT is a type of flat tax that basically neuters some common itemized deductions for many Americans. As a result, the first household will be paying slightly more than $110 per month in additional taxes, which might not seem so bad. But, the second household will pay over $540 more per month in taxes which will be much more painful if the AMT is not fixed by years end.

Then, at the end of this year, were in a whole new ball game. Beginning in 2013, the first household will pay over $450 more per month than they did in 2011  and thats assuming no raise in wages. And, the second household will pay almost $920 per month more! Factor into the equation that these two households represent a major segment of consumers in the US and it doesn't take much to imagine how buying habits will change as a result and what that will do to the economy. If you think high gasoline prices were a drag on the economy, what do you think these higher taxes will do?

Contrary to what you might think, a majority of these households are not savers. They will have difficulty absorbing this cost. Many won't be able to pay car or student loans. Making the home mortgage payment won't be easy either. Job creation will not solve this problem. Quite the contrary, it will cost more people their jobs as economic activity shrinks. Then guess what? If less people have jobs and businesses have less profit, the US government will collect less overall tax - Washington will still have a budget problem.

Now lets look at a successful small business owner example with a spouse and two children who also have some investment income:

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While this small business owner example looks less impacted by the Fiscal Cliff, let me point out some observations and make some comments about this group. First, they are less impacted - on a percentage basis - than other households simply because they benefitted less from the Bush Tax Cuts to begin with. This should dispel the myth that the Bush Tax Cuts only targeted benefits for the wealthy. Next, notice that this group pays a higher Effective Tax Rate (ETR) in 2011 than either of the two households will in 2013 from the prior example. The ETR in the tables above is arrived at by dividing their Total Federal Tax Due by total income before deductions. They just don't pay higher taxes because of their incomes; they pay a higher percentage of their income.

I'm not defending this group because it resembles my own situation. It doesn't. My own situation is closer to those households in the first example. However, I've worked with and for these people and know that most took great risk to create what they have. Before they are able to enjoy the benefits of such an income, most will have to recoup from many years of below average income and or pay back large debts incurred to get the business started. In addition, this group has traditionally been the largest job creators in our economy. If they don't get rewarded for the risk they took, why do it?

This last example reflects how retired persons, not entirely dependent upon Social Security payments, will be impacted by the Fiscal Cliff:

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At first glance, this example group looks to be the most tax favored group of them all. However, the ETR they pay reflects only a part of the story. First, notice that they will see the largest increase in ETR, from the Fiscal Cliff, than the other examples. Next, they have none of their income subject to Social Security, Medicare or Self Employment Taxes. These taxes are assessed on earned income and not assessed on investment income - for anybody - and never before were meant to. Also, in most cases, they've already paid their fair share those taxes over the years on the money they amassed to make those investments. If you added those taxes back, you'd see for 2013 that the lower income retirees ETR is only slightly below than that of the comparable household in the first example; and, the higher income retirees would have a higher ETR.

But this is only part of the story. Investment plays a significant role in the U.S. economy  for both business and government. For business, investment provides the capital which - whether through bank loans or equity investing - helps small a business start up and grow. It funds both residential and commercial real estate so that businesses and families who cant afford to own have a place to live and work from. For federal, state and local governments, investment funds program and infrastructure spending that exceeds the revenues they collect.

Lastly, this group of citizens already subsidizes government coffers through the artificially low interest rates that our central bank has created. In many cases, their investment income has been cut in half while borrowers have benefitted from lower rates. This has not only drastically cut the interest income they rely on but has forced many to take on more risk than they can stomach.

Summing Up the Auto-Pilot Tax Law Changes

The examples presented were not provided to draw comparisons of fairness. The US is currently navigating through a period whereby class warfare is being promoted too much. Nor do these examples expose how the Fiscal Cliff will impact every households financial circumstances in the nation. Rather, these examples are presented to quantify how various households will experience the Fiscal Cliff.

What should be clear is that, if Congress does nothing to address the Fiscal Cliff, we will see a dramatic negative effect on consumption and investment in the US. Couple this with the sovereign debt challenges in Europe and the global economy is battling great uncertainty. Despite their differences, many believe that Congress understands and won't let us fall off the Cliff. Yet, recent experience leads me to believe that well all be on the edge of our seats before we see any solution.

You Haven't Been Dropped From Our List

Since late 2003, I set out to draft and issue a monthly article on a number of topics relating to finance and economics. When I look back at my earlier articles, they were roughly thrown together but provided bits of education that could benefit readers. Over time, they became easier and more enjoyable to read and more and more people desired to receive them. One of my goals was to take a complex topic and make it easier to understand for the average person. And I've received complements from industry peers that felt these articles are witty and insightful. For that, I have much to be thankful for.

In the past couple of years, business has grown to a level that makes it more challenging to create these articles every month. More time is now being spent working with clients and keeping abreast of the turbulent markets we are experiencing. With most of the growth coming from client referrals, it has become more important to set priorities and focus on what I do best  serve clients. Yet, these articles won't stop altogether; they just may become less frequent. And, you won't be dropped from our list unless you request it or some malfunction occurs at our outside list distribution service.

ELF's Outlook and Performance

For the most of this year, we've had from 30% to 60% of our client portfolios holding cash. We are currently holding the highest level of cash we've had all year. A small portion remains positioned in a volatility hedge  as volatility increases, so does its value. The hedge is not perfect, but offers some protection against negative event risk.

Our outlook remains defensive as the European Debt Crisis and Fiscal Cliff get pushed further and further down the road. Global economic indicators are showing signs of deterioration and the last set of corporate profit reports were good but came with negative guidance. Five large money center bank ratings have been downgraded in June by Moody's. Surprisingly, the markets have shown resilience in the face of more bad news than good  but not without some notable ups and downs. It has been challenging to understand this resilience. One scenario that comes to mind is that with money fleeing Europe's banks in search of safe havens, some of it may be flowing into US stocks.

We're prepared to remain defensive until we begin to see greater reason for optimism to sprout. Despite our caution, we regularly screen for investments that look undervalued to be ready should the outlook begin to improve. However, for now, the potential for risk appears to outweigh the potential for reward.

Our portfolio clients ended the month of May down 1.55%. Here are some comparative numbers for you to review:

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For disclosure purposes, past performance is not necessarily indicative of future results and ELF Capital Management LLC (ELF), formerly Hoffman White & Kaelber Financial Services LLC, cannot guarantee the success of its services. There is a chance that investments managed by ELF may lose a substantial amount of their initial value.

ELF is an independent discretionary investment management firm established in February 2003. ELF manages a strategic allocation of primarily exchange-traded index funds (ETFs), and may invest in other carefully selected securities. ELF may also employ hedging techniques, through the use of short positions and options. ELF manages individual portfolio accounts for both individual and business clients.

The ELF ETF Strategy returns presented herein represents a composite of actual results from all client portfolios managed by ELF. Currently, it is the only composite presented by ELF and separate client account portfolio positions are substantially similar, except as may be modified for retirement plan accounts and accounts with net equity of $60,000 or less. There is no minimum account size for inclusion into ELFs ETF Strategy composite and accounts with net equity of $60,000 or less have a tendency to downwardly skew the combined results.

ELFs performance data presented herein includes the reinvestment of dividends and capital gains; as well, ELFs ETF Strategy composite returns are presented after deducting actual management fees, transaction costs or other expenses, if any. ELF charges an annual investment management fee as follows: 1.25% on the first $250,000; 1.00% on the next $750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.

Broad market index information provided is solely for the purpose of comparison. This index data was obtained from third party sources believed reliable; however, ELF does not guaranty its accuracy. An investment account managed by ELF should not be construed as an investment in an index or in a program that seeks to replicate any index. In most cases, investors choose a market index having comparable characteristics to their portfolio as a benchmark. An ETF is a security that tracks an index benchmark or components thereof. As ELF actively manages a strategic allocation of primarily ETFs, selecting a comparable benchmark poses significant challenges. Over time, the broad market indices provided above may exhibit more, similar or less variability of returns and risk than ELFs strategic allocation. As well, the broad market index information provided above reflects gross returns and have not been reduced by any estimated fees or expenses that a person might incur in trying to replicate an index.

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