An Economic Sword of Damocles

The tale of Damocles refers to a mythical courtier to Dionysius, king of Sicily, in the fourth century BC. Damocles flattered the king for his great fortune in being surrounded by such obvious luxury and magnificence. Dionysius offered to switch places with Damocles so he could experience firsthand the luxury enjoyed by the king. Damocles accepted, and sat on the king’s throne. Dionysius, however, had hung a huge sword over the throne suspended by a single horse hair. Upon seeing the dangerous condition, Damocles begged the king to be allowed to leave the throne. Cicero used the anecdote to illustrate that virtue alone was necessary to lead a happy life. It has come down to us as a tale denoting a sense of foreboding engendered by a precarious situation.

One of the most precarious possibilities threatening our economic wellbeing is the potential onslaught of new taxes and reductions of government spending waiting to happen on January 1, 2013. Originally set to expire at year end 2010, the tax reductions were extended two years, and have become a principle part of the national debate prior to the November elections. The legislation created new, lower tax brackets of 10, 15, 25, 28, 33, and 35%, replacing the 15, 28, 31, 36, and 39.6% tax brackets. Taxes on dividends and capital gains were reduced to a unified level of 15%, the marriage penalty was reduced, and the estate tax exclusion was increased. The 2% payroll tax cut is also set to expire at the end of the year. Other relief provisions applied also, all of which will revert to the levels which were in existence in 2001, unless specifically changed by the Congress.

There is more. A host of new taxes are set to kick in. A 3.8% tax increase on all forms of investment income, and special 0.9% income tax on high wage earners also takes effect in 2013. The failure of the so called “super committee” to reach an agreement on deficit reduction will trigger automatic spending cuts of about $120 billion per year starting in 2013. To round out the tax and spending agenda, at current rates of spending another increase in the debt ceiling is very likely to be necessary right after the election.

The sword overhanging the financial markets is the impact these taxes will have on our economic prospects. It has been referred to as the fiscal cliff. Economists of all shapes have been compiling estimates of the extent of the potential slowdown. Many assume the most damaging of possible outcomes. The Congressional Budget Office estimates the drag at about $388 billion, or roughly two and a half percent of GDP, with most of the impact caused by higher taxes. However, even the Administration, which champions higher taxes, is calling for the Bush tax cuts to expire only for households earning more than $250,000. Other changes are certain. The November elections will have a major influence on how lawmakers address these looming issues, but either way the result will be far different from the dire estimates being made today. Investors should not let fear of this impasse dictate their investment decisions.

 

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