Economic News & Analysis - March 26, 2012
Avoiding the tax wall
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

Brian Jacobsen photo

Summary:

  • Under current law, every tax bracket is set to get a bump in rates; the two-percentage-point payroll tax cut is set to expire; capital gains taxes will rise; dividend tax rates are scheduled to increase; and additional taxes will be imposed on individuals earning more than $200,000 a year (or $250,000 per year for a married couple filing jointly).
  • The tax code changes (including the health care reform taxes) could effectively put the economy at 0% growth for 2013 and create another year of pathetic job growth.
  • Regardless of the outcome of the tax code debate, I maintain there is still a strong argument for investing in companies that combine growth with income.
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“In this world nothing can be said to be certain, except death and taxes.” Benjamin Franklin (1789)
“Death, taxes, and childbirth! There’s never any convenient time for any of them.” Margaret Mitchell, Gone With the Wind (1936)

I have yet to meet a person who actually likes paying taxes. Benjamin Franklin drew a parallel between death and taxes. As the April 17 deadline for filing quickly approaches, so, too, does the deadline for U.S. politicians to decide whether the U.S. economy hits what I call the “tax wall” at the end of the year.

In 2001 and 2003, there were significant tax law changes. These changes were set to expire in 2010, but Congress and the president forged a compromise that extended the law to the end of 2012. Part of the compromise included a one-year, two-percentage-point reduction in payroll taxes for employees. That payroll tax provision was supposed to last only one year, but it has since been extended and is scheduled to expire at the end of 2012.

Scheduled tax changes

Under current law, every tax bracket is set to get a bump in rates; the two-percentage-point payroll tax cut is set to expire; capital gains taxes will rise; dividend tax rates are scheduled to increase; and additional taxes will be imposed on individuals earning more than $200,000 a year (or $250,000 per year for a married couple filing jointly). In addition, the top marginal tax rate is set to rise from 35% to 39.6%. Actually, it will effectively increase to 40.5% because part of the health care reform law imposes a 0.9% Medicare surtax on individuals’ incomes in excess of $200,000 or married couples’ incomes of $250,000 or more. The health care reform act will also impose a 3.8% Medicare tax on investment income for these same “top earners,” which applies to dividend and interest income (tax-exempt municipal bond income is excluded).

In 2003, the top capital gains tax rate dropped from 20% to 15%. The 2003 law also created something called “qualified dividends,” which were taxed at the same rate as capital gains. Expiration of the 2003 tax law could lead to capital gains being taxed at 23.8% (20% plus the 3.8% Medicare tax) and dividends being taxed at 43.4% (39.6% for the top tax bracket plus the 3.8% Medicare tax).

Estimating the effects of tax changes

Without discussing the idea of fairness, which isn’t exactly an objective or measurable quantity but rather a matter of personal opinion, what would all of these, or just some of these, tax changes mean for the economy?

In order to estimate the impact on overall economic output, as measured by gross domestic product (GDP) and employment, I performed a statistical analysis relating GDP and employment levels to areas like investment in equipment and software, the size of the population, and various tax rates, all dating back to 1954.

In short, the consequences are not pretty. GDP could be 3% lower than it otherwise would be, and it could mean forgoing the creation of more than three million new jobs. If all the current tax code provisions were to stay as they were for 2011 and 2012, I think GDP growth for 2013 could be 3%. That means the tax code changes (including the health care reform taxes) could effectively put the economy at 0% growth for 2013 and create another year of pathetic job growth.

What about the markets?

Many investors own stock through tax-sheltered vehicles, like traditional IRAs and 401(k)s. Those investors might not be concerned about the capital gains tax rate or whether dividends are taxed as income or at the same rate as capital gains. However, the marginal buyer or seller is vital in determining the current price of a security, and these investors will likely care and take action.

When capital gains tax rates increase, there is a surge in realized capital gains just before the tax increase goes into effect. If investors have the option, they will choose to pay a lower rate rather than a higher rate. This is precisely what happened in 1986 when capital gains tax rates increased. As a result, if capital gains taxes increase—or, if there is the expectation that capital gains taxes will increase—at the end of 2012, I expect there could be additional volatility in the markets as investors attempt to realize gains to avoid paying the higher taxes. It could also put downward pressure on stock prices because investors will want to be compensated for the additional tax they incur.

Regarding the dividend tax rate, an increase could deter corporations from paying out dividends as demonstrated in the 2003 tax reform, which led to a surge in dividend payments, especially from lower growth companies. In my opinion, this led to a more efficient taxing system, which encouraged low growth companies to disgorge excess earnings instead of reinvesting in low growth, or simply wasteful, projects. Treating capital gains and dividends differently, as is scheduled to happen under current law, could undo all these benefits. It could also be a disservice to investors who seem to be searching for any kind of income in their portfolios.

Regardless of the outcome of the tax code debate, I maintain there is still a strong argument for investing in companies that combine growth with income: those companies that can consistently pay dividends as well as penetrate new markets. This is why I especially like U.S. consumer staples (consumer staples should be a staple of every portfolio) that can grow market share in emerging markets. A similar line of reasoning applies to U.S. businesses across the spectrum, which seem to be well positioned to extend their innovations into new markets. However, not every business will fit that mold, which is why working with active portfolio managers that buy well-researched companies can add value.

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