Let's Dive Off the Fiscal Cliff


Are you sitting down? Good, because here are three words that many say should scare investors: the fiscal cliff. Hopefully you didn't choke on your coffee -- or tea, or wine, depending on when and where you read this. Is the fiscal cliff that scary, though? Or is the view from the top worse than the fall?

The changes
If Congress doesn't act, what exactly will change?

  • The capital-gains tax rate increases from 15% to 20%, while the 15% dividend tax rate increases to the income tax rate.

  • The Department of Defense reduces its budget by 10%.

  • Discretionary programs, including education, law enforcement, low-income energy subsidies, roads, and homeland security, will see an 8% cut in budgets.

  • Unemployment benefits will revert back to a 26-week limit from the 99-week limit.

  • The child tax deduction of $1,000 is reduced to $500.

  • A $2,500 tax credit for school expenditures per year for four years falls back to a $1,800 credit per year for two years.

  • The payroll tax holiday that saves 2% on Social Security taxes on the first $110,000 in wages will end.

  • The estate tax changes from a $5 million exemption and a 35% tax rate to a $1 million exemption and a 55% tax rate.

  • Medicare provider payments drop by 2%.

These changes come from several different policies, making it more like a fiscal "staircase" than a cliff. While Congress may not find a solution to all the moving pieces, single parts could be maneuvered to avoid the crash-landing the Congressional Budget Office predicts.

The predictions
If we tumble down this fiscal staircase, the CBO forecasts that next year's GDP would decline 0.5% and the unemployment rate would increase from the current 8.3% to 9.1%. For comparison, the CBO set up an alternative scenario where taxes remain where they are (except the payroll tax holiday) and budget cuts do not occur. In this scenario, instead of a GDP decline, we would see GDP rise 1.7% in 2013, and unemployment would improve to 8%.

However, in 2022, unemployment would sit at 5.3% in both scenarios; GDP growth with cuts would be 2.3%, while under the alternative it would be 2.1%; and the deficit is less than 1% of GDP after cuts, compared with almost 6% under the alternative. Also in 2022, federal debt held by the public could either edge toward 100% of GDP under the alternative or fall to less than 60% of GDP if we endure the cuts. While the immediate future looks bleak if no solution is found, in a decade it seems we would have endured a short-term setback.

But then, can even the CBO predict things a decade from now? Its report offers a bevy of factors that could prove its forecasts false, including faster economic growth, a worse-off Europe, and a surge in oil prices. The report also counts on more economic stimulus in early 2013 by the Fed.

Long-term thinking
No one wants to struggle economically or remove vital safety nets that others depend on to survive and attempt to prosper. The potential hits to important research, infrastructure, education, and security are also scary to think about. However, if we don't address rising debt now, we may bind future progress that would be saddled with higher debt service.

With an election on the way, it's unlikely anything will be resolved before November. This leaves two months of worrying, when it's likely nothing would be solved anyway. In the meantime, investors should review their own contingency plans. With the chance for dividends to be taxed at your income tax rate, it might be worthwhile to look at REITs, which already incur income tax rates for their dividends, or master limited partnerships, which require a more complicated review of the tax code.

To make up for the higher tax rates, REITs like Annaly Capital (NYSE: NLY) and Chimera Investment (NYSE: CIM) have yields above 10%, but these specific mortgage REITs are deeply exposed to interest rate risk. And the high beta, or volatility, of Chimera might be tough to stomach for traditional dividend investors. Timber REIT Weyerhaeuser (NYSE: WY) offers less of a dividend yield at 2.4%, but given no changes in policy, the market-beating capital gains of 34% this year would be taxed at a potentially more favorable rate of 20%.

Fool Jim Royal extolls the virtues of shopping center real-estate REIT Retail Opportunity Investment (Nasdaq: ROIC) , which offers a yield slightly more than 4.4% and the capital-gains prospect of turning from a small cap into a mid-cap. MLP and pipeline operator Plains All American (NYSE: PAA) nets investors an almost 5% yield and has at least doubled the market's returns over the past one-year, five-year, and 10-year periods.

Coming in November
With the fiscal cliff, we could be better off in a decade; without it, we will be better off next year. While we wait for Congress to come up with a solution, come up with an investing game plan that will take advantage of either scenario. To help, you can start off with our premium report on the risks and opportunities for Annaly Capital. And grab your copy of our free report on select stocks that could benefit from each of the presidential candidates: "These Stocks Could Skyrocket After the 2012 Presidential Election."

Originally published