President Obama and Congressional Republicans have reached an agreement on taxes. The plan would extend Bush-era tax cuts for an additional two years for all Americans through 2012.  The tax cuts include individuals making more than $200,000 and couples earning over $250,000.  Although liberals in Congress are publicly against this, it is expected to pass and this is what it means to you for the next two years:

• The current marginal tax rates of 10, 15, 25, 28, 33 and 35 percent would remain unchanged;
• The tax rates on dividends would remain unchanged at 15 percent;
• The tax rate on capital gains would remain unchanged at 15 percent;
• The alternative minimum tax (AMT) would be temporarily “fixed” by indexing to inflation to prevent more Americans from owing AMT; and
• The top estate tax rate would be 35 percent after a $5 million per-person, tax-free allowance, instead of reverting to 55 percent.

What is described above is more or less what the Republicans had been seeking. To agree to it, President Obama and the Democrats exacted a compromise from the GOP: an extension of unemployment benefits to the long-term unemployed for an additional 13 months.  Long term this creates a greater deficit but short term this is definitely good for the economy because it gives us 2 years of certainty on taxes so planning is possible!

The only surprise in the current tax deal is the one-year payroll tax holiday. Currently, the 12.4 percent payroll tax to fund Social Security and Medicare is split 50-50, with 6.2 percent paid by employees and 6.2 percent by employers. The amount is deducted from paychecks earned by every worker on the first $106,800 of their annual income.  The economic stimulus package passed in early 2009 included the Making Work Pay initiative, which gave workers a tax credit against their 6.2 percent share of the payroll tax. The size of the credit varied based on how much each individual earned and was eliminated entirely for those making over $75,000. This special credit was due to expire at the end of the year, and the President had sought to extend it.

The payroll tax holiday proposed as part of this compromise would reduce the individual’s share of payroll tax by 2 percent for 2011 only, and would apply to all Americans. For those earning less than $40,000 this would mean an $800 tax reduction for 2011; for those earning $106,800 or more this would mean a $2,136 reduction. Those in between these two income levels would see a tax reduction equal to 2 percent of wages.

The Making Work Pay credit was unpopular with Democrats because, according to polls, most individuals did not realize they benefited from the credit because it was buried in the 1040; and many Republicans disliked it because it involved giving tax credits to individuals who pay little or no taxes. Many on both sides felt that it was cumbersome and preferred an immediate tax cut visible on paycheck statements. The amazing part is that this little-discussed feature (the tax holiday) has a cost of $120 billion for 2011 alone and is, therefore, a much larger stimulus measure than Making Work Pay.

We expect to see political theatre as the President and Republicans try to get this compromise through Congress.  Already, many Democrats have spoken out against the deal, stating that the President gave too much away in the compromise.  The rise in the market today is an indication that most investors believe the compromise will pass Congress. President Obama, according to the press, was involved in negotiating the terms of the compromise and has firmly put his weight behind this package. He’s unlikely to back down from that position, and many in his party will ultimately follow his lead. In addition, the deal includes some major carrots for Democrats, including the long-sought extension of unemployment benefits.

This is a positive for not only the economy but also for the stock market. Uncertainty about taxes going forward has been an issue for individuals and businesses alike; a failure to reach a compromise was the biggest near-term risk to the economy. The still-fragile recovery could not withstand an across-the-board tax hike at this time.  So, despite partisanship, we are beginning to see the political system start to help, rather than hurt, the economy!