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The fiscal cliff refers to the economic effect of a collection of laws and tax policies that are bound to be adopted at the beginning of 2013. These include new taxes, cuts on spending, tax reductions, and other policy measures. Tax increases are due to the expiration of the Bush tax cuts and reduction of government spending. Collectively, the total to about $600 billion and projections indicate that they will affect the domestic economy and corporate profitability unless changes are made. Financial analysts claim that these effects will result in an escalation of the stock market’s volatility. The stock market is highly volatile and can decline significantly in response to changes in political or regulatory policies.
Since the election of 2012, the Dow has declined by approximately 4%. On the day that President Obama announced the provisions of the fiscal cliff, the Dow dropped by 100 points in reaction to the announcement. The stock market is highly volatile and might collapse unless Congress makes some changes to the fiscal cliff. In addition, it has the potential of causing another recession that might contribute to the collapse of the stock market.
The new taxes and tax cuts proposed in the fiscal cliff will have adverse effects on the stock market. An analysis of the effect of the various types of taxes on market returns revealed a significant effect on the stock market. Corporate income tax, individual income tax, and capital gains tax hurt market returns. However, taxes imposed on dividends do not have a similar effect on the stock market because corporations have the authority to retain earnings instead of paying out dividends. On the other hand, investors can turn to stock options that have low returns. The individual income tax rate harms market returns. For example, the higher the rate of income tax the lower the market returns. This implies that individuals are more efficient in allocating resources to the economy than the government is.
Many investors are worried that the fiscal cliff may interfere with stock market returns because it will increase the vulnerability of dividend-paying stocks. The fiscal cliff has been cited as one of the potential sources of stock market uncertainty unless Congress reacts. However, some financial analysts have stated that there is no cause for alarm. First, many dividend-paying stocks are held in accounts that are not taxed by the government. Therefore, any change in the rate of dividend tax will not have an immediate effect on investors. Secondly, most companies usually raise dividends whenever tax rates increase in order to quell the effects of increased tax on dividends. Thirdly, many companies that pay dividends are in defensive industries that are not adversely affected by changes in the economy. Since they are less vulnerable to decreased earnings, they still perform well during adverse economic conditions.
If the fiscal cliff takes effect without any changes, the volatility of the stock market will increase and bring stock under increased pressure. Analysts have projected that the fiscal cliff might result in another recession if the congress does not take cautionary measures. In case of a recession, investors will have little to worry about because even though dividend-paying stocks will be affected, the effect will not be as immense as on other sectors of the market.
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