America is marching toward the fiscal cliff, and investors are on alert for the consequences of plunging from the peak.
Re-elected President Barack Obama and congressional leaders must decide in the next 54 days whether they are willing to ignore their election-year rhetoric and compromise on raising taxes and cutting government spending.
If they fail to reach agreement on debt reduction, the nation plunges off the cliff in a $700 billion mix of automatic tax increases and spending cuts after Dec. 31. That will be such a huge hit to the spending power of American households and businesses, says Federal Reserve Chairman Ben Bernanke, that the U.S. will drop back into recession unless political leaders rally quickly.
If the year ends with the issue unsettled, individuals and companies will start paying higher taxes. At the lowest income levels, taxpayers will face a 15 percent tax rate instead of 10 percent. Consumers will react to their effective pay reductions by spending less, while company profits are likely to be pressured. Some companies will also be stung by reductions in sales as the government cuts back on purchases from businesses.
In anticipation of government cuts, shares in defense contractors such as Lockheed Martin fell Wednesday. After all the cuts, look for layoffs at some businesses too.
One the first likely changes would be an end to payroll tax breaks that were implemented to stimulate the economy. The other would cutting back on extended unemployment benefits, Bank of America Merrill Lynch economist Ethan Harris said in a recent report.
At this point, nothing is guaranteed. Stocks will rise or fall in the next few weeks as the political debate provides hints of year-end compromise or paralysis. The Dow Jones industrial average plunged 313 points Wednesday, in part because of the prospect that a politically divided government — with Democrats controlling the White House and Senate, and Republicans the House of Representatives — will let the nation go over the edge rather than actively sign on to unpopular spending cuts and tax hikes.
Investors have known since the nation's debt ceiling debate in August 2011 that this year's deadline would arrive and impose tax increases and spending cuts. But they have been "surprisingly complacent," said Russ Koesterich, BlackRock iShares global chief strategist. They pushed stocks to levels that will be unsustainable if the hit comes.
Even after Wednesday's sharp decline, the Dow industrials remain up about 6 percent for the year. The Standard & Poor's 500 index is up about 11 percent.
Koesterich thinks investors naively assume that political leaders eventually will do what they need to do to avoid a recession. A common belief is that by year-end, Capitol Hill will buy time by offering a framework for planning deficit reduction and tax reform in 2013, and offer some type of "down payment" to show good faith this year.
Once talks get serious, just about all taxpayers will face concerns. A wide range of studies done on the nation's debt and budget deficit — whether from left or right leaning sources — have suggested that neither tax increases nor spending cuts alone will be enough. A combination will be needed.
As the nation seeks solutions, Jeffrey Sherman, DoubleLine Multi Asset Growth fund manager, assumes one issue will be an age feud. With "an unemployment problem and an aging population, who sustains the retirees?" he asked.
Proposals to cut spending by targeting Social Security and Medicare have focused on raising the retirement age for collecting benefits, taxing affluent people more than they now pay toward the benefits and basing retirement benefits somewhat on financial need.
Other changes that have been discussed have included getting rid of tax deductions for mortgage interest, charitable donations and contributions to 401(k) retirement savings plans at work.
Such controversial changes aren't likely to surface without a major overhaul of the tax system and probably would take years to implement. Not only would these changes upset individual taxpayers, but businesses have an interest in seeing specific tax breaks, like the mortgage deduction, kept alive.
"We assume that after some bruising negotiations most, but not all, of the austerity associated with the fiscal cliff will be avoided," said JPMorgan economist Michael Feroli.
Yet financial advisers are preparing clients for possible modifications next year in capital gains taxes and dividends. In pre-election discussion about the tax system, there has been talk of raising capital gains taxes from 15 percent to 20 percent and taxing dividends at the same rate income is taxed. That could be as high as 39.6 percent, plus a 3.8 percent surtax, for the highest income taxpayers — a tremendous change from the current 15 percent rate.
With the prospect of those changes coming in 2013, analysts expect some taxpayers to sell stocks before the end of the year so they can pay taxes at the 15 percent rate instead of a higher rate next year.
End-of-year tax-related selling could add to the stock market's volatility.
Yet the decline in the stock market Wednesday did not come from fear of the fiscal cliff alone. European issues have come back into the spotlight, with European Central Bank leader Mario Draghi on Wednesday speaking about an eroding European economy, and even Germany close to a recession.
While the U.S. election has been resolved, there remains a world of worry to contemplate.