Market Perspectives - July 2012
2012 mid-year outlook: Looking past the cliff
The economyBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
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%.Chart 1: History of U.S. tax rates
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 taxesAs investors, we are concerned not only with the health of the economy, but also with the impact that tax changes could have on investments. In 2003, when qualified dividends were treated the same as long-term capital gains, corporations began paying out more in dividends. Instead of relying on share buybacks, often financed by issuing debt, the equal treatment of capital gains and dividends let corporate directors unlock shareholder value instead of being incented to retain earnings in perhaps marginally worthless projects. Instead of focusing on managing firms to get tax advantages, managers could pay more attention to managing firms to increase shareholder value.
Chart 2: Lowering the tax rate on dividends has triggered more dividend payments
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
Two-percentage-point payroll tax cut passed in December 2010 to go away.