Andy Friedman, principal at the policy-analysis shop the Washington Update, on Wednesday offered advisors a preview of the legislative battles poised to jar the markets and, potentially, push the nation to the brink of default and threaten a government shutdown.
"My theory is that Congress acts only when we have what I call a forcing event, an event that makes inaction intolerable. The fiscal cliff was a forcing event. Nobody in Washington wanted to go back into recession," Friedman said on a conference call hosted by Sammons Retirement Solutions. "We got a compromise, but we also got three additional forcing events coming up."
Up next: a March 1 deadline to avoid $1.2 trillion in long-term, across-the-board government spending cuts that were postponed in the fiscal cliff deal; a March 27 deadline to approve new appropriations funding to keep federal departments and agencies operating; and a potential mid-May deadline to raise the nation's borrowing limit and avoid a default on debt payments.
Friedman warns that a standoff over each of those "forcing events" has the potential to shake investor confidence and roil markets, particularly if more of the now-familiar partisan rancor that has attended recent fiscal fights prompts ratings agencies to downgrade the U.S. credit rating.
"First of all I think we may see some volatility in the markets in the next few months," he said. "I know the markets liked the fiscal cliff compromise, they've have a nice run-up. But as we get closer to the sequestration, spending cuts, shutting down the government, defaulting on our debt, and as the media starts playing up the fact that Washington can't reach agreement ... I think the markets could get nervous and we could see them go down. That's what happened in August of 2011 when we hit the debt ceiling. Now, again, I'll say we're not going to default on our debt. This is not going to be happening. So there's nothing fundamentally wrong with the markets."
The fiscal cliff resolution saw tax rates for top earners (households with annual income over $450,000) increase for both ordinary and investment income, while rates were held steady for everyone below that threshold. But the package included little to address the spending cuts that congressional Republicans have been demanding as part of any approach to deficit reduction. Democrats, meanwhile, continue to press for more revenues, even after the fiscal cliff deal.
Friedman, like many other observers, has pointed out that nibbling around the edges with cuts to discretionary spending -- the appropriated portion of the federal budget outside of big entitlement programs like Medicare and Social Security -- won't achieve the significant deficit reductions that Republicans are calling for. Those same GOP members have said that new tax-rate increases are off the table following the fiscal cliff resolution.
"There's not enough juice in discretionary spending cuts to get where the Republicans want to go," he said. "Raising more rates -- that's going to be a non-starter."
While congressional Republicans will certainly hold out for nondiscretionary cuts in negotiations ahead of the looming deadlines and renew calls for reforms to entitlement programs, advisors should be most concerned about adjustments to the tax code that could recalibrate their clients' investment strategies, according to Friedman.
Short of a wholesale overhaul of the federal tax code (an idea endorsed by leaders in both parties, in principle), which, like entitlement reforms, would be a tall order ahead of the March deadlines, lawmakers are likely to turn their attention to more incremental adjustments, such as potential caps on deductions for mortgage interest, charitable donations, interest from municipal bonds or employer-paid health-care premiums.
"The changes I'm particularly worried about are on the tax side," Friedman said. "If you can't raise tax rates, and you want to raise more revenue, you would normally go through the Internal Revenue Code provision by provision, and you would decide which ones you want to keep and which ones you don't. We can't do that. We don't have enough time. And so the talk in Washington is some sort of new cap or limitation on tax exemptions and deductions."
President Obama, for instance, has proposed capping exemptions and deductions at the 28% tax rate, which would have the effect of increasing the tax burden on high-end earners. An individual in the highest 39.6% tax bracket, for instance, would only be able to deduct certain items at 28%, unlike the current system which allows deductions equivalent to a payer's tax bracket.
As a political matter, however, some of the credits in the code make improbable targets for tax increases.
"My guess is that the most egregious of these -- health insurance premiums and tax-exempt interest on bonds -- is not going to get through Congress," Friedman said. "I don't think Congress is going to have an appetite for those."
Far more likely, he projects, is that lawmakers could align around a proposal to impose an exemption cap on itemized deductions like mortgage interest and charitable donations. In that event, advisors might consider counseling affluent clients to prepay charitable contributions -- rather than waiting until the end of the year -- and to divert cash resources toward paying down their mortgage to lessen the impact of potential deduction caps.
Also on the chopping block are tax provisions that critics have identified as loopholes, such as preferential treatment afforded to carried interest for hedge funds and private equity funds, master limited partnerships (MLPs) and certain wealth-transfer techniques.
Of those, the treatment of carried interest, or the profit that a manager of a private equity or hedge fund takes as compensation, as capital gains is a prime target for reform.
"Most people believe that's inappropriate," Friedman said. "If you sell something and you have produced it through your efforts or your services, that should be ordinary income on the sale. So that's probably at the top of the list for change."
Other reform proposals could include changing the tax status of publicly traded MLPs to eliminate their flow-through status and tax them at corporate rates, though Friedman sees it as unlikely that such a shift would be applied retroactively to existing MLPs.