Investors should keep a close eye on the lame-duck Congress and President Barack Obama following Tuesday's election. Higher tax rates could take effect Jan. 1 if leaders are unable to quickly resolve differences over taxes and spending, an outcome that could cause Bush-era tax cuts to expire. For investors, the current 15 percent maximum rate on long-term capital gains could increase to 20 percent. Rates on dividend income that currently top out at 15 percent would also rise, with investors in the highest tax brackets paying substantially more. However, those rates may not take effect if Congress delays or otherwise averts tax increases.
Here's a look at three possible scenarios for addressing the so-called fiscal cliff, according to a research report issued by Fidelity Investments:
1. CONGRESS FAILS TO ACT BEFORE YEAR-END
The outcomes of congressional races and the presidential contest could further complicate attempts to achieve a consensus on addressing the fiscal cliff. As a result, Congress and President Obama could fail to reach any agreement, causing current tax rates to expire, and leading to automatic federal spending reductions. If such a fall over the cliff happens, the new Congress convening in January would likely reinstate certain tax cuts and spending policies early in the year. That way, the full impact of the fiscal cliff would not be felt. However, even a temporary expiration of the tax cuts could cause financial markets to become more volatile.
2. A LAME-DUCK CONGRESS REACHES A COMPROMISE
Congress and President Obama reach an agreement to extend some or all of the Bush-era tax rates for a few months. Such a deal would give the next administration — either Obama's, or that of Republic challenger Mitt Romney — time to work on a longer-term deal next year. Alternatively, a compromise could involve an agreement to extend specific tax and spending policies while allowing others to expire. Such an end-of-the-year deal could raise the current ceiling on the nation's debt, and include some type of downpayment to reduce long-term debt.
3. A GRAND DEAL IS ACHIEVED
Some political leaders view the fiscal cliff and the lame-duck congressional session as a unique opportunity to achieve comprehensive tax reform and long-term deficit reduction. A bipartisan group of lawmakers has been working to build support for such a potential "grand bargain." Even if such a deal isn't reached, any congressional compromise could include a downpayment on deficit reduction, or establish a framework for how the debate on deficit reduction will proceed next year.
As for Fidelity's expectations? "Ultimately, we believe it is likely that Congress will act either this year or early next year to avert portions of the fiscal cliff from taking effect," the report concludes. "The elections and the state of the economy would impact the shape of any deal."
Fidelity notes that a more serious debate about long-term deficit reduction and tax reform could take place in 2013.