Economic and Investment Implications of the Tax Compromise

February 15, 2011

By Chris Dardaman, CPA, CFP®, CIMA®, CAIA® 

General Overview
Uncertainty and lack of confidence in the economy and the government on the part of both consumers and businesses have been major obstacles for the current economic recovery. The passage of the recent tax compromise bill reduces some of that uncertainty and should produce positive implications for the U.S. economy and investment markets. Eliminating the tax uncertainty, at least for two years, is a short-term positive, although a permanent fix of the income and estate tax rates would have been even more beneficial.

Unfortunately nothing substantial has been done yet to reduce the bloated government spending, which must be addressed. As Janet Novack of Forbes recently said, “Bipartisan compromise is a lot easier when both sides are getting to add to the deficit with spending and tax cuts they want.”¹ Serious cutbacks in all areas of federal spending are coming, and will likely be painful. However, we think the current political situation could create the environment where the impossible becomes the inevitable. Don’t be surprised to see some positive bi-partisan fiscal changes in the next two years that no one thought possible just a few months ago.

Positive Impact on Stocks
Lower taxes on dividends and capital gains will be positive for stocks. What investor would not be more optimistic over a 15% federal tax on dividends instead of a 39.6% tax? And the 15% long-term capital gains rate both tastes great and is less filling than the proposed 20% rate before the new tax bill passed. Keeping the dividend rate low will motivate companies to continue paying, and possibly increasing, their cash dividends. With huge cash surpluses on corporate balance sheets, increased dividends help put more money in motion into the economy — a definite positive.

Negative Impact on Bonds
Lower taxes on ordinary income will be positive for bond holders’ tax returns, although taxes are nowhere near the top of the bond market’s list of concerns. Those would include large deficits, future inflation and rising rates. The Fed’s recent QE-2 actions were intended to hold down longer-term rates, but have had the opposite effect thus far. The bond market knows that the additional bond issuance required to fund our large national deficit will put pressure on future interest rates,  likely causing them to rise in the coming years. Also, the increasingly positive global economic data tends to indicate that the global recovery is picking up steam, which worries bondholders. The bottom line: do not expect much out of bonds the next few years.

Impact on Consumers and Investors
Lower income taxes will be positive for consumers, as they will have more money to spend. Since over two-thirds of our economy is made up of consumer spending, this will help increase the flow of money, helping drive further economic activity. (This assumes people spend and do not just use the extra dollars to pay down debt or save, which are both good for personal balance sheets but not helpful to the nation’s economic recovery.) With lower taxes, investors will have more capital and greater incentives to invest, which will generally fuel further investments, additional jobs and more long-term revenue for the government. Confidence in the future is a very important part of the psyche of both consumers and investors. Government stability in terms of taxes and regulation is essential to provide consumers and investors with clarity and confidence so they are motivated to spend and invest.

Conclusion
J.P. Morgan economists David Kelly and Andrew Goldberg estimate that if all of the Bush era tax cuts had been allowed to expire, it would have reduced disposable income by roughly 1.25% starting in the first quarter of 2011.² Obviously, this would have been a major drag on economic growth. Eliminating the income tax increases, coupled with the one year reduction in Social Security taxes and the accelerated deductibility of investment spending in 2011, should help promote economic growth and provide incentives to businesses to hire and invest. But it comes at a cost – with estimated annual federal budget deficits of over $1 trillion projected for each of the next four fiscal years. Eventually both political parties will have to stop their out of control spending and tax cuts and administer the tough fiscal medicine needed. All in all, the removal of some uncertainty should improve consumer and investor confidence and be positive for the economy and the investment markets. But the deficit has to be addressed, and yesterday is not too soon.

¹ Janet Novack, Forbes, “Washington’s New M.A.D. Doctrine: Mutually Assured Deficits.” December 6, 2010.
² Andrew Goldberg and David Kelly, JP Morgan Market Insights - Market Bulletin, “The Implications of the Tax Compromise," December 17, 2010.