2011 Tax Deal - Quick Thoughts

Posted on December 8, 2010 by David Laidlaw 

The following is a link to a Wall Street Journal synopsis of the recently announced tax deal between the Obama administration and the Republican Congressional leaders:

http://online.wsj.com/article/SB10001424052748704250704576005571915798378.html?mod=WSJ_PersonalFinance_PF2#articleTabs%3Darticle

Please note that the following analysis depends on the actual passage of legislation that formalizes the agreement and that this passage is not a forgone conclusion.  The main tenets of the tax deal are that it preserves the current income tax schedules for the next two years and keeps in place a preferred rate of 15% for long-term capital gains and income from dividends.  There are two new provisions not currently in the tax code already.  There is a provision that calls for reducing the employees payroll tax from 6.2% to 4.2% for tax year 2011.  The other new item concerns increasing (over 2009 levels) the estate tax exemption to $5 million and reducing the rate to 35%. 

This structure, regardless of its merits, allows individuals and businesses to plan for the future without the overhang of uncertainty that existed before.  

The extension of the status quo and the payroll tax reduction are stimulative since otherwise tax rates would have risen significantly draining money from the private sector.  Economists predict the tax deal to increase economic growth by 0.5 – 1% per year over the coming year.  Accelerated economic activity and sales growth is positive for stock prices since it should lead to higher profits.  However, the bond market has sold off and interest rates rose sharply yesterday after the deal was announced.  The bond market did not like the combination of increased spending through the extension of unemployment benefits in conjunction with lower tax revenues.  This combination leads to higher deficits and lower credit quality for US debt.  Yields on 10-year Treasury notes have increased from 2.95% to 3.26% in the last two days.  The higher interest rates that come with this package could offset the stimulative impact of lower tax rates and  reduce corporate profits since borrowing would become more expensive.

Publicly listed corporations now will be able to set their dividend policies for the coming year.  Many companies have significant cash balances on their books that could be returned to shareholders through dividends.  Since these dividends will continue to be taxed at 15%, companies will now be much more eager to increase their payouts than if dividends were taxed as current income.

If the proposed legislation is not signed into law, tax rates will rise across the board and individuals and businesses will most likely delay spending and investment until the future is clearer.