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Tax Tidal Wave Alert — Investors Beware!

April 4, 2012 3 minute Read by John Prestbo

At some point this year, investors will start worrying about the steep rise in taxes and government-spending cuts that are scheduled to take effect January 1, 2013. And when that happens, watch out below! These are the tax terrors lying in wait:

  • The holiday on payroll taxes will expire, meaning paychecks will shrink by as much as 2%.
  • Income tax rates will revert to levels that prevailed before 2003, pushing the top rate on earned income to 43%.
  • Capital gains taxes will jump to 25% from the current 15% rate.
  • Taxes on income from dividends, now at 15%, will be levied at rates for ordinary income.

The tally of these tax increases plus “automatic” cuts in federal government spending (because the President and Congress couldn’t agree on a fiscal repair plan last year) amounts to roughly 3.5% of gross domestic product, says David Wessel in his “Capital” column in The Wall Street Journal. That big of a hit on the U.S. economy will probably stop the recovery dead in its tracks, and conceivably shove us back into recession. That’s why some observers, Wessel included, think that after the election but prior to year-end the President and the lame-duck Congress will try to devise some way to divert the tax tidal wave before it swamps us. At this point, Wessel thinks there is a 25% chance for a “grand compromise,” a 25% chance that nothing will happen and the higher tax rates will take effect, and a 50% chance the politicians will “kick the can down the road.” Much will depend on the campaign and election outcome, of course. But what if the markets don’t wait until Nov. 7? The stock market is generally thought to look ahead to economic conditions six to nine months over the horizon. That suggests these tax worries could start affecting securities prices this summer or at least by Labor Day. Will we have to endure market mayhem while the politicians attend their job fair? Ironically, the more the markets cringe at the prospect of our fiscal time bomb exploding the more likely a reasonably solid political solution will emerge. The cost, unfortunately, could be very high.


Author

John Prestbo
John Prestbo

2012 Economic Growth Fellow

John Prestbo is retired as editor and executive director of Dow Jones Indexes. Previously he was markets editor at The Wall Street Journal. He has co-authored or edited several books over the past 30 years. The most recent is “The Market’s Measure: An Illustrated History of America Told Through the Dow Jones Industrial Average,” published in 1999 by Dow Jones Indexes. His column, Indexed Investor, appears on the highly regarded “MarketWatch” business and finance website. He received his bachelor's and master's degrees from Northwestern University.

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