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Taxmageddon, the fiscal cliff and the markets

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Now that the presidential election is over, the media spotlight has shifted to Taxmageddon, the looming tax increases that will automatically begin in 2013. The spotlight has also shifted to what's known as the fiscal cliff — the deep federal spending cuts scheduled to kick in automatically next year.

The only way for Congress to avert these events is to act and for the president to sign substitute legislation addressing the federal budget deficit. Absent this, Ernst & Young has calculated, the effect on taxes will be an increase in the capital gains tax rate from the current 15 percent to a maximum of 24.7 percent and an increase in the rate on dividends and on interest from 15 percent to a maximum of 44.7 percent.

Most economists agree that if the government allows this to happen by failing to substitute more gradual spending reductions, the nation could tailspin into recession. And many market analysts agree that the closer Congress gets to the Dec. 31 deadline for addressing Taxmageddon, the more the financial markets may suffer.

So there are three important questions for investors:

1. Will Congress pass legislation in time to avert Taxmageddon and keep us from going over the fiscal cliff?

The answer to this is "probably." Since the election, President Barack Obama and Speaker of the House John Boehner have both publicly expressed a general willingness to compromise. Whether they can make a deal remains to be seen. Yet one thing motivating both sides to compromise is the political risk from not doing so.

After all, the reason the stakes are so high now is that the government essentially kicked this can down the road in 2010, figuring they'd deal with it later (with each party hoping to have more power at this point). We are now at the end of the fiscal road, so kicking the can any further, triggering the events outlined above, isn't an option.

2. If the government does act before the end of the year, what will this legislation look like and what effects will it have on the economy?

Political analysts speculate that a deal would likely impose some tax increases, but not nearly as high as those listed above, or create new revenue by reducing deductions and loopholes. In addition, there will probably be gradual spending cuts. That's because both parties agree that otherwise, the effects on the economy would be devastating.

3. If the government doesn't act, what will be the effect on the financial markets?

Though some are speculating that a failure to make a deal would mean devastation for the markets, the primary focus is the potential impact on the economy. It's important to draw a bright line between the economy and the markets. Too many people confuse the two, assuming that they're one and the same. Remember that in late 2009 and all of 2010, the economy was wracked by recession but the stock market surged ahead and did quite well.

If Congress fails to pass legislation that the president will sign, the economy will probably suffer temporarily from the sudden decrease in federal spending. Many investors, confusing the economy with the markets, see this as spelling doom for the investment markets, but that wouldn't necessarily be the case. If they're wrong in their speculation and sell their investments, but the markets end doing well, this mistake would be a another example of how dangerous it is to attempt to outsmart Mr. Market, who reflects known information in prices.

The likelihood that many investors will be wrong regarding any given trend is high, as clearly demonstrated by history. Of course, there are times when some investors are just lucky, many ways to be wrong and precious few investors who can be lucky twice by selling at the right time and then buying back in before the train leaves Dodge. This is nothing more than an attempt to time and outsmart the markets — a loser's game, for sure.

Let's not forget that one reason the stock market started coming back in 2009-10 is that so many people panicked and dumped their shares after the 2008 meltdown, creating enticing buying opportunities for investors who were happy to take the shares off their hands at temporarily depressed prices. These wise buyers were later rewarded with an increase of more than 100 percent in the broad-based U.S. equity markets.

The key, as always, is to have a sound written financial plan that accounts for inevitable market declines. With your gains in some investments helping to cushion declines in others via a prudent, fully diversified all-weather portfolio, you can continue to invest with confidence while those around you fall prey to their emotions, driven by the fodder of daily media deadlines.

Tim Decker, a fee-only financial planner, is president of ISI Financial Group in Lancaster. He is the author of "The Sleep-Well-At-Night Investor" and host of the radio program "Financial Freedom," which airs at noon Saturdays on WHP-AM 580. Contact him at www.isifinancialgroup.com.

This content is based upon information believed to be accurate by ISI Financial Group Inc. However, it should not be relied upon for legal or accounting purposes. Past performance is not indicative of future performance. Investments involve risk, including the possible loss of principal. Always seek professional advice before making any financial or legal decisions.

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Write to the Editorial Department at editorial@cpbj.com

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