Countdown to the Tax-Rise Torpedo

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Now that the Democrats are running Congress, the risk that Nancy Pelosi will launch a tax-rise torpedo at the stock market has risen. Investors ignore this risk at their peril.

Make no mistake about it. Taxes on capital gains and dividends have an important impact on stock prices. The bull market of the 90′s drew strength from cuts in these taxes and from extensions of tax shelters within retirement and related accounts. The Mellon, Kennedy, and Reagan tax cuts led into robust bull markets. Carter’s waffling on tax cuts accompanied an uncertain up and down stock market. The Hoover-Roosevelt tax increases accompanied a major depression in the economy and the stock market. Significant alterations in tax rates have prolonged effects on both the economy and asset markets.

When the capital gains and dividend cuts were extended last year for two years, Pelosi criticized the bill: "It will increase our debt, cut taxes for the superrich, and do little for Americans struggling under skyrocketing gas prices." On Meet the Press, she said of the tax cuts: "Well, I, myself, am against them…"

If evidence is needed for the oncoming torpedo, observe that the newly elected House of Representatives has already voted for at least three measures to raise taxes. The House changed a rule such that now only a simple majority can raise taxes. It installed PAYGO rules that require tax increases to fund any tax cut. When the current tax cuts expire, the Democrats will be able to feign reluctance to increase taxes and point to PAYGO. Third, the House raised the minimum wage, which acts as an excise tax that businesses pay for labor. In addition, rumor has it that Democrats wish to remove the income ceiling on Social Security ($97,500 in 2007.)

Along with other Democrats, Pelosi assails borrowing to finance deficits: "It’s absolutely immoral for us to heap those deficits on our children." Borrowing, of course, gives rise to future tax payments to pay interest and principal. So what is the distinguishing virtue in the Democrat’s fondness for tax and spend as opposed to borrow and spend? There isn’t any. Both financing methods spring from the same poisoned well, which neither party ever addresses, namely, government spending.

Democrats will be providing relief from the horror of the alternative minimum tax while continuing to fund the welfare-warfare-regulatory state. Where will they turn to for money? Sooner or later, despite the fact that more Americans than ever own stock, they will either let the capital gains, dividend, and estate taxes expire, or they will end them sooner. The chance of these happening rises dramatically if the White House goes Democrat in two years. The stock market discounts the future. When and if it foresees serious tax increases ahead, this will hasten the demise of the current uptrend or contribute to any ongoing downtrend. The current uptrend is already relatively old at 46 months anyway.

Despite their professed antipathy to deficits, which is a ploy to justify tax increases, Washington Democrats face deficits as far as the eye can see. They will finance them through borrowing just as Republicans have. They will play with taxes to win political points, with a bias toward increasing them.

A wild card is whether or not Democrats will pressure the Federal Reserve to print money. My theory is that the Fed obeys the Treasury, and the Treasury obeys the president. In the long run, the Fed is always inflating. It’s only a question of whether it is inflating more or less. This depends on who is president. Under semi-populist presidents like Carter who appoint dense businessmen as Treasury secretaries rather than shunt them off to Commerce, we get more inflation. They like devaluing the dollar to favor big export industries. Under a Clinton who appoints a Wall Street magnate like Rubin to maintain the dollar, we get a dose of mild restraint. At the moment, it’s a minor miracle that the Fed has shown restraint for several years.

The existing Treasury secretary is a Goldman Sachs man, so we probably will see the restraint at the Fed continue while he is there. He is bound to understand the immense threat of inflation heating up. Any serious rise, as shown in a popular measure such as the CPI, will cause Treasury bill rates to ratchet up. The interest expenses of financing the deficit will then rise. At the same time, higher rates will slow down the economy and tax collections, further increasing deficits.

The bond markets are therefore a threatening force waiting in the wings to restrain both government spending and inflation. Would that they were an even greater force and an active force right now. However, somehow buyers of U.S. securities find them attractive enough that rates remain rather modest.

Looking ahead, if the election of 2008 starts to swing toward the Democrats, the inflation uncertainty will rise and the markets will reflect that. At some point as the winner clarifies, and also as the winner’s economic biases clarify, this uncertainty will resolve. But the point is, we can now foresee that the uncertainty will probably rise and affect stock and bond markets negatively. Gold will follow or even lead the monetary base. If it rises, so will gold.

It should be noted that the stock market hates uncertainty, and conflict between the Executive and the Legislative branches generates uncertainty. With a split between the parties, we will see that being another source of increased uncertainty.

Furthermore, investors should bear in mind that the stock market is experiencing a super-downtrend that began in the year 2000 and that may last 15—20 years. During such a long-term bear trend, the overvaluations of the preceding super-bull market are gradually eliminated until prices end up at depressed levels. While this occurs, the component uptrends such as we are now having tend to be much less robust than the uptrends within a super-bull period.

The overall level of the stock market is still richly valued, and until that condition is corrected the risk of stock market investing remains relatively high. Add to that the risk of tax increases, intramural government conflict, and greater uncertainty in inflation and the investment picture is much more cloudy now than a few weeks ago.

Higher risk is invisible and intangible. It lies in the mind of the investor. It is on my mind, and now you know what I think at this time.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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