The Independent Market Observer

1/7/13 - It Starts Today

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jan 7, 2013 7:40:33 AM

and tagged Fiscal Cliff, Politics and the Economy

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“The tax issue is finished, over, completed.” — Mitch McConnell

“The tax issue is resolved.” — John Boehner

Remember I said that the recent fiscal cliff deal, with the tax issue taken off the table, would make the next round of negotiations harder? I rarely get confirmation this quickly. Today, in the Wall Street Journal and the Financial Times, Republican leaders in both houses of Congress have publicly taken taxes off the table. In their view, the deal made 99 percent of the Bush tax cuts permanent, and that’s that.

Which leaves the country with a problem . . . As I noted, the deal we have covers about 15 percent of the problem, leaving the remaining 85 percent to be dealt with. It will be tough if not impossible to cover that with spending cuts, so something has to give. I expect Republicans to hold out successfully on rates, as the Democrats have effectively conceded on that.

The New York Times has an interesting article on its front page that gives an idea of where this discussion has to go. The article, “Major Companies Push the Limits of a Tax Break,” has the story in the headline, but the details are interesting. It deals with Section 1031 of the tax code, which allows tax-free exchanges of in-kind assets. For example, if a couple owned an apartment building and was tired of managing it, they could exchange it for another property, such as a drug store, which is less management intensive. The theory is that, since they are not realizing any gains but just rolling the investment over into a similarly risky asset, there is no justification to tax the transaction. Companies take advantage of the same techniques for other capital assets used in their normal business operations, resulting in significant tax savings.

This is an example of a law that enables companies and individuals to defer or avoid taxes. As such, if rates remain constant, laws like these will have to be changed to limit tax deferrals and raise more revenue. The high-profile story is a sign of the potential strategy. When was the last time you saw a tax law on the front page of the NYT? These battles will be increasingly fought out in public. Elimination of tax breaks are the only path forward for additional revenue, therefore we will be seeing much more public naming—and attempted shaming—of individual tax breaks.

It will be relatively easy for Republicans to hold the line on rates but harder to hold the line on individual tax breaks. This, combined with the Republican internal debates, is highlighted in a WSJ article on the Virginia governor’s race. Virginia has long been a marquee Republican state, but the party now seems to be divided between two candidates, which could allow the Democrat to win. Internal Republican debates will become more relevant, as the party attempts to pull together in negotiating with the White House. Given the public pressure that will certainly be brought to bear, party unity will be essential if the Republicans plan to hold their line.

The battle begins today, as the lines have now been drawn.

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