2012 mid-year outlook: Looking past the cliff

The economy

Now that the Greek elections are over, media—and investor—attention will likely shift to the upcoming U.S. elections. It's not as though people weren't already talking about the U.S. elections, but it was playing second fiddle to Greece until now. We believe the big issue is what happens with taxes. Under current law, the two-percentage-point payroll tax cut will go away at the end of the year. Additionally, income tax rates are scheduled to return to pre-2001 levels, capital gains taxes will increase, dividend taxes will go up, the alternative minimum tax will capture more people in its clutches, and estate taxes will rise. None of these on its own is positive, let alone all of them taken together, especially when you consider that the economy is barely stumbling along. According to our forecasts for the economy, the prospect of taxes increasing—what we refer to as the "tax wall" and what the media has called the "fiscal cliff"—has dampened economic growth by a full percentage point for 2012. If taxes do increase, economic growth could be cut by up to three percentage points in 2013. However, if taxes do not go up, we forecast 3% growth in gross domestic product (GDP) in 2013. In essence, a tax increase could effectively flat-line the economy, which would not be beneficial to workers, investors, or politicians who need to get re-elected. Sadly, we don't think the uncertainty around the tax wall will be resolved until after the November elections, meaning the economy and markets will continue to be stuck in a rut until then.

It is easy to point to periods of time when tax rates were higher and the economy was humming along. However, it is not just the level of taxes that matters, but the direction of change as well. The starting point of the economy also matters. While it is one thing to raise taxes when the economy is near full employment, it's quite another to raise taxes when the unemployment rate is above 8%.

While a top marginal tax rate of 35% is low, it's not as low as it has been in the past. When making historical comparisons, it's important to see what level of income the top rate applied to. For example, in 1944 the top income tax rate was a confiscatory 94%. That rate, though, only applied to income that was in excess of $200,000—in 1944 dollars. Adjusting for inflation, that is equivalent to more than $2.5 million in 2011 dollars! Also, the whole structure of taxes was different back then. In 1944, dividend income was not taxed, so many high-income individuals obtained their income from dividends instead of ordinary income.

Capital gains and dividend taxes

Chart 2: Lowering the tax rate on dividends has triggered more dividend payments

Sources: FactSet, Internal Revenue Service (IRS), and authors' calculations

Because companies need to compete for financial resources and investors care about after-tax returns, putting a tax wedge between before-tax and after-tax returns—or making that wedge bigger—just makes it more expensive for businesses to raise capital. The result shouldn't be too surprising to anyone: When it's more expensive to raise money, less money is raised than otherwise would have been raised, and less investment is made than otherwise would have been made. Since investments in property, plant, equipment, research, and employment serve as the foundation for economic growth, a larger tax wedge diminishes the productive capacity of the economy. Economists would also point out that taxes create a "deadweight loss" for society as a whole, which arises because the tax distorts people's behaviors and the tax revenue doesn't make up for the amount of investment lost. This is why we think tax reform is such an important issue and not one that is likely to be resolved before the end of the year. We believe the most likely scenario is that after the November elections, Congress, the Senate, and the president will wait until the last feasible moment to extend the existing tax provisions until the next session of Congress and deal with things then. In other words, the election might bring a bit more certainty as to what could happen with taxes, but an actual fix will be a long time in the making.

Scheduled changes and comments

Income tax rates to revert to pre-2001 levels. Top tax rate to go from 35% to 39.6%. Additional 0.9% Medicare tax on wages of those in the highest tax bracket to fund the Affordable Care Act.
Comment: Most businesses (95% of the number of business entities, 54% of business income, and 54% of private-sector employment) pay taxes at the individual tax rate, not the corporate rate. Sixty-four percent of business income accrues to those in the top tax bracket (18% to those earning $1 million or more). Raising even just the top tax rate could reduce 2013 GDP and employment growth significantly.

Qualified dividends, currently taxed at 15% for those in the top tax bracket, to be taxed as income. Additional Medicare tax of 3.8% on investment income to fund the Affordable Care Act.
Comment: Corporations are likely to pay less in dividends, favoring share buybacks instead. Taxing dividends results in double taxation of corporate earnings—once at the corporate level and then again when distributed to shareholders in the form of dividends. This would increase the cost of equity capital for businesses, encouraging them to take on more debt than they otherwise would and reducing the amount they invest in new projects. Those 65 years old and over are likely to be the hardest hit because they earned 48% of all dividend income in 2008, making up 6% of their adjusted gross income.

Long-term capital gains tax rate to go from 15% to 20%. Additional Medicare tax of 3.8% on investment income to fund the Affordable Care Act.
Comment: Increases the cost of equity capital to businesses, resulting in businesses taking on more debt than they otherwise would and reducing the amount invested in new projects. Those 65 years old and over are likely to be the hardest hit because they earned 30% of all capital gains in 2008, making up 12% of their adjusted gross income.

In addition, various other tax code provisions are subject to change. For example, the estate tax rate is set to increase from 35% to 55%, while estate and gift tax exemption will drop from $5 million to $1 million, and the alternative minimum tax (AMT) exemption amount will also drop, meaning significantly more taxpayers will have to pay AMT.

The views expressed are as of 7-1-12 and are those of Chief Portfolio Strategist Brian Jacobsen; Chief Equity Strategist John Manley; Chief Fixed-Income Strategist James Kochan; and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.