Election 2012: Takeaways for Investors

November 8, 2012

Michael Townsend
Vice President, Legislative and Regulatory Affairs, Charles Schwab & Co., Inc.

With the 2012 presidential election in our rearview mirrors, let's take a look at the results and discuss what investors might see in the coming weeks and months.

A status-quo election means more policy gridlock

The election seemingly did nothing to change the balance of power in Washington: President Obama was reelected, Democrats retained control of the Senate and Republicans maintained control of the House of Representatives. So, despite all evidence that Americans are frustrated with policymakers' inability to come together and solve problems, the election produced the outcome least likely to change that—the same polarized dynamic that has tied Washington in knots for the last two years is likely to continue.

On top of that, the election did nothing to clarify how Congress will resolve the looming "fiscal cliff," which includes the expiration of the Bush tax cuts and the payroll tax cut at the end of the year, and the automatic spending cuts that take effect at the beginning of 2013. The Republican-controlled House has called for a one-year extension of all the tax cuts, while the President and Senate Democrats have insisted that the Bush tax cuts must expire for the wealthiest filers. Neither side appears willing to budge on those basic positions.

Tax increases are a real possibility

Given the stalemate between the two parties on the Bush tax cuts, odds are growing that all cuts will expire at year-end and taxes will increase for everyone on January 1, 2013. This would mean the following:

• All income tax rates would increase.
• Capital gains would be taxed at 20%.
• Dividends would be taxed as ordinary income.
• The estate tax would revert to a top rate of 55% in 2013.

Presumably, the two parties would then focus substantial energy in 2013 on a broader overhaul of taxes that is retroactive back to the beginning of the year. This would be complicated and confusing, but it is possible because most taxpayers would not feel the hit of the increased taxes until they file their returns in early 2014.

"Fiscal cliff" discussions tabled until after Thanksgiving

Serious negotiations on the fiscal cliff aren't likely to start until after Thanksgiving, and likely won't be resolved until mid-December. Congress returns to Washington November 13, but most of the energy that week will be devoted to leadership elections, orientation for newly elected members and practical things like allocating office space for the new Congress. Lawmakers will then return home the week of Thanksgiving and reconvene on November 27, which is when the serious discussions will likely begin. It may be the third week of December before we see a resolution.

And despite negotiations, we don't think there will be any "grand bargain" before the end of the year. There is neither the time nor the inclination in Washington to try to forge any kind of broad agreement on taxes, spending and entitlement reform in the coming weeks. Instead, we think the debate in Washington through the end of the year will focus on ways to put off as much of the fiscal cliff as possible into 2013.

A short-term fiscal cliff agreement by year-end?

There seems to be a growing consensus in Washington that there are two "must do" action items related to the fiscal cliff: Fix the Alternative Minimum Tax (AMT) and postpone the automatic spending cuts.

• If the AMT is not "patched" before the end of the year, an estimated 25-30 million Americans will pay higher taxes for 2012—meaning on the returns they file this coming February, March and April. Neither party wants this to happen.
• There is bipartisan agreement that the automatic spending cuts set to kick in on January 1, 2013—$55 billion from defense spending and $55 billion from non-defense spending—are too harsh for the fragile economy, particularly in states that have a significant defense industry presence.

A fiscal cliff agreement that patches the AMT, delays the spending cuts and puts in place some deadlines and a process for tax reform is a plausible December outcome.

Possible revival of the payroll tax cut 

The payroll tax cut, which lowered employees' shares of payroll taxes from 6.2% to 4.2%, has been in place for the past two years and is set to expire at the end of 2012.

For much of this year, there appeared to be little interest in restoring the tax cut for 2013. However, Democrats in Washington recently began calling for an extension of the cut, expressing concern that the increase would hit lower- and middle-class workers hardest. One idea currently floating around in Washington is to split the difference: Increase the share employees pay by one percentage point in 2013—to 5.2%—as a way to lessen the impact.

Health care reform is here to stay

While the Affordable Care Act may see some changes down the road, any notion of repealing the law is now off the table. That means that two new tax increases will take effect on January 1, 2013:

• A 0.9% increase in Medicare taxes for individuals earning more than $200,000 and couples earning more than $250,000; and
• A new 3.8% surtax on unearned income, including capital gains and dividends, for filers above the $200,000 (individual) and $250,000 (couples) income thresholds.

Dodd-Frank isn't going anywhere

Republicans spent much of the election season calling for repeal—or at least a heavy reworking—of the financial regulatory overhaul law. While many Democrats in Washington acknowledge that aspects of the new law need fixing, they are reluctant to open up the whole law for revision.

The focus now will be on completing the lengthy backlog of regulations to implement the law, including controversial issues like the Volcker Rule (which restricts US banks from making certain kinds of speculative investments that do not benefit their customers), the regulation of derivatives, and determining which companies pose a systemic risk.

The next few weeks are anyone's guess

Congress' post-election or "lame duck" sessions are notoriously unpredictable. Emotions will remain raw for several days after an election this closely fought. We expect an unpredictable few weeks replete with rumors and misinformation, but we don't foresee much clarity until well into December.