Tax Compromise — January 2013

January 25, 2013

Dow Jones Average: 13,825
S&P 500 Index: 1,495


Tax Compromise


The U.S. Congress took the country over the fiscal cliff at midnight on December 31, 2012,
and then quickly opened a parachute on January 1st, to avoid a likely plunge in the economy
brought on by a shift in tax rates. The whole exercise was rife with political gamesmanship.
Most Republican office holders had taken the Grover Norquist pledge to never vote for a
tax increase. The Bush era tax cuts expired automatically on December 31st, 2012, which
temporarily reactivated the higher rates of the Clinton era tax code. By waiting until January
1, 2013 to address the tax issue, members of the House and Senate could claim that they
voted to restore the recently expired, Bush era tax cuts for 99% of Americans, while simply
taking no action on rates for the top 1% of taxpayers. Technically no legislators voted for
a tax increase, even though taxes on higher income Americans will be going up for the first
time in ten years.

The tax compromise agreed to by Congress and the President conformed quite closely
to the policy imperatives laid out by President Obama during the 2012 election. Federal
tax rates will go back to the Clinton era code of 39.6% for individuals earning $400,000
per year and joint filers reporting $450,000 or more in income. Rates will not change, but
taxable income will increase for those making over $200,000, as deductions will be limited
for that group (another Clinton policy that is coming back). Taxes on long-term capital gains
and dividends will go from 15 to 20 percent for those in the $400,000 and over bracket.
In addition there are a number of tax provisions passed as part of The Affordable Care
Act (popularly referred to as Obamacare) that take effect for the first time in 2013. These
special, health care related taxes will raise even more revenue from taxpayers reporting
more than $200,000 in income. Starting in 2013, this group will incur an additional 3.8%
tax on long-term capital gains and dividends, and a rise of .9% in the part of payroll taxes
designated for Medicare. While the Democrats succeeded in levying more taxes on wealthier
Americans, the Republicans took some consolation in seeing the Bush era tax cuts become
permanent for the vast majority of taxpayers. There is no expiration date this time built into
the new tax law, no more fiscal tax cliffs coming up in the future.

After all the brinkmanship the hard reality is that the tax compromise barely impacts the
Federal budget deficit. Wealthier taxpayers will feel the sting, about 70 billion dollars per
year collected in total from a couple million taxpayers. For some individuals the tax increase
could be in the millions. Unfortunately the extra revenue increase does little to close the one
trillion dollar, annual, budget deficit. The United States spends about 24 percent of GDP
(a measure of total economic output) on Federal programs, and only brings in 15 percent
of GDP in taxes to cover those outlays. The tax compromise narrowed the gap, but not by

The Federal Government is caught between popular support for entitlement programs
and antipathy to higher taxes. The solution has been to increase Federal borrowing. As long
as the government can borrow trillions from U.S. citizens and foreign investors at virtually
no interest, it would appear to be a fairly painless solution. If investor demand for U.S.
Treasuries tapers off, the Fed steps in with printed money (actually electronic credit) and
buys the treasuries itself. The tax compromise, which barely dents the deficit, guarantees
that more debt will be needed to cover government spending for the foreseeable future.

Current Strategy

While the U.S. stock market got back on the rally track in 2012, it was very much a stealth
rally from our perspective. There was no dominant theme that drove prices higher, and few
stocks that stood out on an individual basis. Many stocks were flat on the year, while others
suffered steep declines. Different sectors of the market went in and out of favor quickly as
hedge funds and other big investors continually shifted gears. At times it seemed that stocks
were falling as much or more than they were rising. But when the dust had settled the Dow
Jones was up by about seven percent on the year, and the S&P 500 Index had gained sixteen

We had a hard time finding the keys to making money in the 2012 market. We prefer
markets that are thematic in nature, led by individual companies that stand out from the
pack. We look for companies that are undervalued and could gain 50% over a period of two
to three years. Our style is not well suited to a trading environment where winners are in a
state of constant rotation, and gains are relatively small, short-term, and fleeting. We will be
making some modest adjustments in our strategy for 2013, broadening the base of holdings
to capture more potential outcomes.

Return to Archive