Politics, Taxes, and the Markets
August 15, 2012
We got a lot of feedback from last week’s e-mail asking about the Bush Tax Cuts and what would happen to the markets if nothing is done to extend them. This led me to the logical tie into politics, given that this is an election year and the bipartisan bickering about the Bush Tax Cuts. There is an old saying, “Never talk about Politics, Religion, or Money in polite company.” Given that I’m in the business of giving financial advice, I guess it won’t be impolite to proceed.
We have over 350 households under our care. Our clients have opinions that range across the full spectrum of possibilities. I have my own opinions, of course. But I will keep this as clinical as possible and avoid as many landmines as possible. This may be easier said than done.
Political Parties, Elections, and Market Performance:
Historically speaking, the markets like having political balance. If either political party has too much power, there aren’t checks and balances to the system. Without this balance, bills and budgets get railroaded through the system.
Shown below are historical Dow Jones Industrial Average returns during different political situations from March 4, 1901 to October 12, 2012. Please note that the returns below have been skewed due to some extreme markets during the great depression.
Democrat President, Democrat House 7.3%
Democrat President, Republican House 9.6%
Republican President, Republican House 7.0%
Republican President, Democrat House 2.2%
From the 1900 election through the 2008 election, there have been 28 elections. 66% of the time an election year has shown positive growth within the markets, with a 7.5% average annualized return. The worst year was 2008, down -33.8%. The best year was 1928 when the Dow Jones was up 48.2%.
Year: Election Year Post-Election Year
Incumbent Democrat Wins 8.4% 0.4%
Incumbent Democrat Loses -2.3% -4.5%
Incumbent Party Wins 15.1% 5.0%
Incumbent Party Loses -4.4% 6.2%
Post-election years haven’t fared as well. They’ve only been up 50% of the time. The average return was 5.5%. The best year was 1932, up 66.7%, and the worst year was down -32.8% in 1936.
The Bush Tax Cuts:
The so-called Bush tax cuts are scheduled to expire at the end of this year. Due to the election year, and the ever increasing partisan atmosphere in Washington D.C. it seems more and more likely that little will be done until 2013.
Here is what will happen if nothing is done:
Tax Brackets: Income taxes for all Americans will go up. Currently, the tax brackets are 10%, 15%, 25%, 28%, 31%, and 35%. The 10% bracket will go away, and the 15% tax bracket will be the new lowest tax bracket. The 25% bracket will be replaced with a 28% tax. The 28% bracket will be replaced by a 31% tax. The 33% bracket will be replaced by 36% taxes, and the 35% taxes will now become 39.6%. The bottom line is everyone will experience higher income taxes.
Capital Gains Taxes: Tax payers in the 10% and 15% tax bracket paid 0% capital gains taxes. This will increase to 10% next year. For the rest of the population, capital gains taxes will go up to 20%.
Dividend Taxes: Tax rates for qualified dividends have been at 15% since 2003. Starting in 2013, dividends will once again be taxed as ordinary income. If you are at the 39.6% income tax bracket, the taxes on your dividends will more than double from what you pay today.
Estate Taxes: The exemption levels for estate taxes have been going up over the past several years, while the tax rates on money above the exemption level has dropped significantly. Today, there is a $5 million dollar exemption per person (if you are married and have a Living Trust this goes up to $10 million). The exemption will drop to $1 million ($2 million for couples with a Living Trust) next year, with estate tax rates rising from 35% to 55%.
Payroll Taxes: Congress extended a 2% cut on the amount that taxpayers pay in social security taxes. This expires at the end of this year. This means your pay check will drop by 2% for the first $110,000 you make.
Health Insurance Tax: Under the current law, your wages are subject to a 2.9% Medicare payroll tax. There will be an additional 0.9% Health Insurance Tax applied to wages in excess of $250,000 for joint tax returns, or $200,000 for single filers.
Investment Income: Additionally, under the new Health Insurance Tax, investment income will be taxed an additional 3.8% for joint filers above $250,000 in income, and for single filers earning in excess of $200,000.
Marriage Penalty: In days past, married couples filing jointly paid double the taxes than that of a single person. This year couples filing jointly enjoyed a 33% discount. Next year, it will go back to double.
Phase-Out Rule for Deduction: This is an extremely complex subject, but if not maintained many itemized deductions for mortgage interest, state and local taxes, and charitable donations will be reduced or lost for couples with $175,000 in income or higher ($87,500 for single filers).
Getting Past the Political Rhetoric:
Realistically speaking, I don’t think that either party has incentives to extend the Bush Tax Cuts during this election year. Instead, they will want to put their name to a new tax cut bill (the “Obama Tax Cut” or “Romney Tax Cut” depending on who wins the Presidential election). They will do this in the face of $1.2 trillion in automatic spending cuts and the need to raise the debt ceiling again. If both political parties don’t come out publically and promise to address the pending tax hike in early 2013, it may adversely affect the market.
It is also being said that the sun setting of the Bush Tax Cut would be the largest tax increase in United States History. In absolute dollar terms, it would be. But it’s a bit of a deceiving statistic. The U.S. Economy is 80 times bigger than it was in the 1940’s. That is why we discuss economics in terms of percentage of GDP. The 1941 tax hike was 2.2% of GDP. The 1942 tax increase was 5% of GDP. Next year’s looming tax increase would represent 2.6% of GDP. A huge tax hike, but not the biggest our country has seen. Putting it a slightly different way, the 1942 tax hike increased the federal revenue by 71%. The 1941 tax increase and the sunset of the Bush Tax Cut would increase federal revenues by 32% and 16% respectively.
Why This Matters:
Our discussion about the Bush Tax Cuts is important especially when coupled with the United States debt and deficit issues. When comparing ourselves to the European Debt crisis, we are in much worse shape. Our deficit to GDP is 7.6%. If you remember last week’s e-mail, the EU27 is at 4.5% deficit to GDP. Our debt to GDP has gone over 100%. The EU27 is at 87.5%. We obviously have major problems.
For those of you who have heard me speak publicly, I discuss the U.S. debt and deficit situation in an analogy tied to weight loss. “If you are trying to lose weight, is it better to eat better, or exercise more?” The answer is easy… Both! The same is true of our economy. This country needs to cut its spending, but also needs to generate more revenue. Increased revenue can be generated by either growing your economy or increasing taxes. None of that matters if we continue to spend more than we make. Just like you can exercise as much as you want but if your caloric intake is greater than what you exude, you will continue to gain weight.
The Impact on the U.S. Markets:
The U.S. economy is in too precarious of shape to withstand a huge increase in taxes. Despite popular belief, our political leaders have a vested interest in seeing our country, economy, and markets get onto stronger footing. A large tax increase will cut into discretionary spending, putting our weak economy back into a recession. Regardless of political party, our politicians know this. It would be political suicide to not act in some way.
Most likely, a solution will not be found until it is forced on them. Expect a lot of bipartisan fighting and a game of political chicken before any tax reform is passed in 2013. This uncertainty will add to volatility in next year’s market. Expect the same thing to happen regarding the debt ceiling and the need to increase it.
Tax increases don’t necessarily translate into bad markets. Just like a tax cut doesn’t mean the markets will go up. If left unchecked, however, I do believe that the sunset of the Bush Tax Cuts will push us into a recession unless congress passes a new tax cut bill and provides further government stimulus.
I was directly asked about how the Bush Tax Cut sunset would affect dividend paying stocks. There have been two dividend tax rate increases since 1980. The first was on November 5, 1990 and the second in August 10, 1993. In both cases, the markets were up six months after the tax increase went into effect. In both cases, dividend paying stocks did not perform as well as their non-dividend paying counterparts. Most studies being done on the impact of the Bush Tax Cut sunset believe there will be little impact to dividend paying stocks as compared to their non-dividend counterparts. They site that those companies which are increasing their dividends or have strong underlying businesses will still find a lot of demand, especially by pension funds. Slower growing businesses with high income are expected to be impacted, like Utilities.
Our government is being forced to play a balancing act of fiscal responsibility, while trying to grow our economy. Job growth, not just lowering unemployment (we’ll talk about this in a future e-mail) is at the core of the solution. We will be monitoring this situation, and tactically making changes to your portfolio in an attempt to protect and grow your investments during these trying times.
Jeffrey J. Powell
Managing Partner, Polaris Wealth Advisers, LLC
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