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Taxes and the Stock Market

revenues-and-expenses

[Credit for much of the following comes from the writings of hedge fund manager John Thomas.]

No matter what anyone promises you today, this week, or this year, your taxes are going up. At $1.6 trillion, the budget deficit is so enormous that bringing it into balance merely through spending cuts is a mathematical impossibility. Chopping funding for Planned Parenthood and National Public Radio just isn’t going to do it, in spite of the impact of the soundbite.

If you own your own home, have employer paid health care benefits, save for your retirement, earn money from capital gains or dividends, and put in a check when they pass the dish around at church every Sunday, you are the biggest beneficiary of the current tax system. You are about to take a big hit. Check out the hit list below that is floating around Congress, and the tax revenues that the termination of these tax breaks will raise:

$264 billion– Tax the health insurance premiums paid for by employers.

Washington Logic: Should those without employer provided health care subsidize those who receive it as an employee benefit?

This is the amount raised by taxing company provided health insurance as regular income. If this gets implemented, the impact will be felt across the Consumer Discretionary Sector as people will have less in their pockets for discretionary spending.

$100 billion– Eliminate the home mortgage interest deduction

Washington Logic: Should renters be subsidizing homeowners?

Kiss that home mortgage interest deduction on loans under $1 million goodbye. If this gets implemented, it will devalue homes and lead to another leg down in the real estate bear market.

$100 billion– End the tax deductibility of charitable contributions.

Washington Logic: Should those who don’t go to church subsidize those who do?

If this gets implemented, universities, churches, and the social safety net take a big hit, meaning there will be even more pressure to raise income tax rates at the State and Federal level to do even more wealth redistribution to pay for the drop in voluntary charitable contributions. Rising income taxes – not necessarily the absolute levels, but rather the rate of change – have a negative impact on almost all areas of the stock market

$52 billion– End the deduction for 401k contributions

Washington Logic: Should those without savings subsidize those who save money for retirement?

This is the argument that will be made to end tax deductibility of 401k contributions. If this is implemented, look for a major correction of 2007 proportions as the cash flow from 401k deferrals is a major input into Mutual Fund purchases in the stock market.

$39 billion– End the step-up in cost basis received on inherited assets

Washington Logic: It’s not their money, so why shouldn’t they pay more in taxes?

If this is implemented, it will incrementally cut down on trading volume as beneficiaries will hold the assets they inherit instead of selling them.

$36 billion– Tax capital gains as regular income.

Washington Logic: Only the rich have capital gains, so why shouldn’t they pay more?

When the 15% tax rate was implemented in 2003, it was a proximate cause of the rally in the stock market out of the NASDAQ Crash lows. Everyone’s 401(k) plan recovered from the crash, not just those of the rich – if that hadn’t happened, there would be even more strain on Social Security. If this is implemented, look for a significant correction in the market as the rising tax rate devalues the embedded profits in a portfolio.

$31 billion– Tax dividend income as regular income.

Washington Logic: The poor don’t have investment income, so why not raise this tax on the rich?

As with capital gains, when the 15% tax rate was implemented in 2003, it was a proximate cause of the rally in the stock market out of the NASDAQ Crash lows. Everyone’s 401(k) plan recovered from the crash, not just those of the rich – if that hadn’t happened, there would be even more strain on Social Security. If this is implemented, look for a significant correction in the market as the rising tax rate devalues the net earnings potential of the companies in a portfolio.

Please note that these measures only raise $586 billion a year, or just 45% of last year’s deficit. If we eliminated all deductions and credits, we could raise $1 trillion – at 76% of last year’s deficit we are still $300 billion short of closing the spending gap.

Without raising tax rates, the remaining money will have to come from cutting Medicare, Medicaid, Social Security, and Defense spending. Realistically, it will be politically impossible to get any of these changes implemented since the 2012 election campaign has already begun – neither side will want to appear to be giving in as they need to shore up their voting bases.

As an alternative, an energy tax (Cap and Trade) and a national value-added tax (a European-style VAT) are on the table and viewed as ways to fund the deficit without cutting entitlement benefits or raising income taxes.

The Cap and Trade tax will be described as impacting the excess profits of energy companies and the VAT hides the tax in the production process so it isn’t as readily visible to consumers. Both of these taxes, however, will be passed onto to consumers in the form of higher prices and the impact to the stock market will be similar to increases in income tax rates.

None of these hikes would be necessary if our economy grew at a 7% real rate instead of 2%. This is one of the reasons tax rates in emerging countries are so low – the economic vitality brings in ever-more tax receipts to fund government activities.

America’s long term growth rate is falling, not rising, and our budget problems are going to get worse, not better. What happens if interest rates rise for the world’s largest borrower? When the Fed stops buying Treasuries as QE2 ends this Summer (they have bought 70% of all Treasuries issued during QE2), will interest rates go up or will the Chinese step in and fund our deficit? Will they only agree to do so only if they are paid more to loan us the money? I’ll take the over on this one.

Obviously none of this is positive for equity investors but given the 2012 election, the government will do everything in its power to pump the stock market higher in the hope that the wealth effect generated by rising stock prices will make any future changes more palatable.

Are we pushing our problems onto the backs of future generations or will our kids be alright?

We’ll see.


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Mark