The Bush Tax Cuts—What Happens in December?

The financial markets hate uncertainty and the 'Mother of All Uncertainties' is looming in December, when Congress is supposed to decide what will happen to the Bush tax cuts, which are set to expire at midnight on Dec. 31. This will become a dominant, and potentially negative story for the markets in the second half of this year.

Most investors assume that there will be a fix, extending the tax cuts for most Americans, before Congress goes home. But of course, most investors and Washington watchers assumed there would be a fix last December on the estate tax, but the lawmakers abdicated. The gridlock is so pervasive that it could happen again.

There are three scenarios for the tax cut end-game, and unfortunately it may not be certain which one will prevail until mid-December.

Scenario One, 15% chance: Congress once again could gridlock, failing to extend any of the Bush tax cuts, which means we’ll wake up on Jan. 1 with all rates roughly 3 percentage points higher, and dividends taxed as ordinary income, with the top rate at 39.6%. This would be an extremely negative scenario for the markets, and would generate fears that the economy once again could plunge into recession. It’s unthinkable that Congress would be that irresponsible, but with this Congress nothing is out of the question.

Scenario Two, 30% chance: Congress could throw up its hands, unable to make the fixes President Obama wants, and decide a week before Christmas to extend the Bush tax cuts for another year. Many conservatives, ranging from Harvard’s Marty Feldstein to CNBC’s Larry Kudlow, argue that with the economy still fragile, it’s not a good idea to raise taxes on anyone. Most Republicans would buy this idea, especially if the economy weakens and the GOP receives a major mandate in November.

Scenario Three, 55% chance: The most likely—but far from certain—scenario is that President Obama gets what he wants: Congress will extend the tax cuts for individuals earning less than $200,000 and families that make less than $250,000. The President promised to do this during the election,and if he breaks that promise, as George H.W. Bush did, he could become a one-term president, as Bush was.

Under this latter scenario, taxes on “the rich,” would rise, with the top rate going from 35% now to 39.6%; the capital gains rate would increase from 15% now to 20%, and the dividend rate probably would rise to 20% also. But many of the provisions such as the dividend rate—and the always contentious estate tax rate—will have to be changed by Congress during December, a major wild card for investors.

We don’t feel comfortable telling clients that there’s a high probability of any of these scenarios occurring—and that’s the point. Confusion will reign, uncertainty will prevail, until December. And that’s not a good story for the markets.

Greg Valliere is Chief Political Strategist at the Potomac Research Group, a Washington-based firm that advises institutional investors on how government policies affect the markets. Greg has covered Washington for over 30 years, starting his career as an intern at The Washington Post, then co-founding The Washington Forum in 1974 to bridge Wall Street and Washington. He has held several positions, including Director of Research, for Washington-based firms, including the Schwab Washington Research Group. Greg is an exclusive commentator for CNBC-TV, where he appears regularly on most of the network’s programs.