Taxing Times

April 19, 2012

It’s tax time, everyone’s least favorite time of year. Even those receiving refunds are pretty grumpy about the whole endeavor. But since the average tax rate Americans pay  will be one of the lowest in the last fifty-plus years, we should be celebrating. 

We’re dedicating this issue of the newsletter not to the ins and outs of mutual fund and ETF taxation and investment strategy, (we’ve got about 10+ years of that in the can if you'd like  to review our archives) but to a discussion of the role taxes may play in the market going forward. Not tax strategy or the potential increase in capital gains tax rates and buying and selling behavior such change may cause, but broad, nation-level tax issues and what they could mean for the market and economy.

Ever since the Great Real Estate Recession (which is really what it should be called) investors have been waiting for the next shoe to drop. Their pessimism has kept money stuck on the sidelines during a market that's done remarkably well since its March 2009 lows – although like many homes, it's still underwater. Normally, money follows returns.

The next “Lehman Moment” was expected to occur as the result of 1) a great debt default by American states and municipalities 2) a massive double-dip recession that would begin as soon as the stimulus ran out 3) a European debt collapse beginning in Greece and spreading throughout the region 4) massive inflation and/or a collapsing dollar caused by Federal Reserve shenanigans 5) general decline of the past-its-prime USA ,similar to what Great Britain suffered decades ago as emerging markets become the new global leaders, and, of course 6) U.S. debt panic or default, possibly fueled by crazed politicians.

Suffice it to say, we're three years into the stock market recovery with no collapse materializing. We’ve been pretty optimistic the entire time, and have thrown cold water on most of these fears. But that doesn’t mean the future is all sunshine.

Our next recession and ensuing market slide could happen as we go about the painful process of closing the gap between government spending (sky-high) and tax revenue (now at multi-decade lows when expressed as a percentage of GDP). Since taxes are not going up until 2013, this won’t be a "double-dip recession," because too much time has passed. It will just be a recession, and probably a fairly mild one in the grand scheme of things. But it could scare stocks down and bonds up. 

The trouble is, broadly speaking, this country has been running a stimulus program for a decade, as long as our portfolios have been cranking away. To us, stimulus is any time the government lowers taxes and/or deliberately increases spending to boost the economy and then makes up the difference in borrowing.

Normally, we would expect some sort of spending and tax cut package to get us out of a recession. Perhaps economists can debate the benefits of such “Keynesian” economic policy. It doesn’t really matter. Any president knows that when times are tough, you cut taxes and increase spending to get reelected. 

This time around, we decided to double-down on stimulus by adding another round of stimulus to the already existing stimulus (remember the Economic Growth and Tax Relief Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003?) In addition to increased government spending, some of it automatic (unemployment, Medicaid, etc.) some of it not (Cash4Clunkers, the new healthcare plan, and payroll tax cuts,) we extended the expiring old pile of tax cuts. 

Now it seems like half the country thinks the solution is spending cuts, and the other half things it's in tax increases, and in all likelihood, they're both right. Broadly speaking, it doesn’t really matter how the gap is closed. It's still going to be almost a trillion dollars of turbo boost disappearing from the equation each year.

Best case, it’s going to be an economic slowdown. Ideally, we’ll back out of spending relatively slowly and over a long time horizon, with some cuts now and some kicking in years down the road, like moving out the age of enrollment for Social Security.

Hopefully, the new revenues will also kick in over time, predictably, and in ways that don’t deter economic growth. Worst case, we’ll try to fix decades-old problems overnight. An example would be removing the government from the home lending market all at once. Let’s be honest. Government insurance designed to lower mortgage rates for loans just shy of $1 million, and tax deductions for up to $1.1 million in  mortgage debt? Even for vacation property, that's  a little ridiculous, given that the median home price is under $200k. But fixing this in one year could cause another cycle of sharp price declines. 

This mess took decades to make, and it will take decades to fix. Either inaction or too much action, too soon, could lead to a real crisis. Slowly getting back on the right track will just cause a recession. Perhaps the healthiest one ever.

Look on the bright side. If we raise taxes and cut spending, and maybe even let interest rates go up from zero, we can always cut taxes and increase spending and lower rates the next time the economy slips on a banana.

But we'd better hurry. The truly scary scenario is what will happen if we have another recession and are still running the tax cuts and spending from the last two recessions when it hits. Then what will we do?