Tax Update

The American Taxpayer Relief Act of 2012 was a politically attractive compromise for both parties that addressed the income tax most on voters’ minds but delayed for two months the more difficult issue of the budget cuts outlined in the Budget Control Act of 2011. Thus the act provided clarity to the revenue half of the budget picture, but the expenditure side remains uncertain. The reductions in income and capital gains taxes from the Bush tax cuts were made permanent for individuals with annual income under $400K and couples with annual income under $450K. At income levels above this threshold the top income rate will increase from 35% to 39.6%, and the capital gains rate from 15% to 20%. Qualified dividends continue to be taxed at the lower capital gain rate. Additionally, Obamacare adds a 3.9% Medicare tax on investment income and a 0.9% tax on salaries for incomes above $250K for a couple ($200K for an individual), making the new top tax rates on ordinary income and capital gains 40.5% and 23.9%, respectively.

While higher taxes will take a bite out of returns, nothing in the new tax code warrants a dramatic change in investment strategy. The differential between capital gains rates and ordinary income has narrowed – previously top ordinary income rates were 2.3 times larger than capital gains rates while currently they are 1.7 times. This change modestly reduces the disadvantage for investments that generate ordinary income such as MLPs or high yield bonds.

The increased tax revenue will have only a modest impact on federal budget deficits – according to studies by the Brookings Institute the reduction in deficits over the next ten years will be around 7%. Without spending cuts, the increased revenue will not be sufficient to get the budget deficit to a sustainable level of 2-3% of GDP – the level at which government debt remains a fixed percentage of GDP.

The uncertainty over the budget and continued intervention of the Federal Reserve in the financial markets means that government will continue to be a major driver of financial markets in 2013. The proper strategy remains to focus on high quality assets and avoid attempting to chase headlines or sentiment.