3 Ways Fiscal Cliff May Impact Taxes

As 2012 draws to a close, Americans watch and wait as a major showdown unfolds in the nation's capital. The stakes are high: If the federal government can't hammer out an agreement by year's end, expiring provisions of the tax code threaten to raise taxes on millions of families at every income level.

To help you anticipate the possible outcome of the "fiscal cliff" -- and how the markets may respond -- USAA experts offer their perspectives on how this legislative negotiation could affect the nation's tax code. While failure to reach agreement by Jan. 1 also will trigger automatic spending cuts, our experts here discuss how Washington's actions could impact your taxes.

Three Potential Outcomes

Dan Brouillette, senior vice president of government and industry relations at USAA, sees three ways the debate could play out during the coming weeks.

1. Most likely: A bridge of compromise

While there's a growing appetite for tax reform, Brouillette believes there simply isn't time for legislators to hammer out a major new agreement before Dec. 31. Democrats and Republicans may agree in principle to forge a wider deal later in 2013 and take the first steps toward it by:

• Maintaining current income tax rates for all taxpayers, regardless of how much they earn.
• Collecting more taxes from people at the higher end of the income scale by limiting their deductions and increasing the taxes they pay on investment gains and dividends.
• Extending many other expiring tax provisions, including those that protect millions of taxpayers from the alternative minimum tax.

"Politically, this allows both parties to claim victory. Democrats will have raised revenue from top earners, while Republicans will have avoided increases in income tax rates," Brouillette says.

This is what investors also are expecting. "At this point, the markets are clearly pricing a compromise that leans toward higher taxes on those at the upper end of the income scale," says Matt Freund, senior vice president of investment portfolio management at USAA. Since it's already reflected in current stock and bond prices, Freund says, this potential outcome isn't likely to prompt a big swing in the markets.

2. Less likely: Full expiration -- but only temporarily

If both parties remain deadlocked on New Year's Eve, Americans will wake the next day to find themselves subject to higher income, investment, payroll and estate taxes.

"If this happens, I'd expect stock and corporate bond prices to fall, as investors anticipate the impact of an additional $500 billion of money being diverted from the economy and into Washington," Freund says. "On the other hand, Treasury bond prices might climb, since the additional federal revenue would put a big dent in the country's trillion-dollar deficits and raise confidence that Uncle Sam will keep making interest payments."

If the tax provisions expire, it probably won't be long until many of them return, Brouillette says. He anticipates Congress would take quick action to turn back the clock and restore 2012 tax rates, except for Americans at the highest income levels.

3. Least likely: The punt

Congress may once again choose to forgo making big tax decisions and simply pass an extension of the existing tax structure that lasts six months or even a year or two. Brouillette and Freund agree that while this outcome may be the least likely, it could be the most harmful to the nation's economy.

"An extension of the status quo might spark a rally in stocks and corporate bonds," Freund says, "but a failure to address the nation's growing $16 trillion-dollar debt could be bad for Treasury bonds in the short run and bad for our economy's fundamentals over the longer haul."