’Tis the Season

Politicians are duking it out in a timely battle over taxes, debts, and deficits. But what will be the market impact when a winner emerges?

Story Highlights:

  • Politicians on the Hill are embroiled in a battle over taxes and spending—a seemingly age-old debate.
  • While we remain politically agnostic, we’re big fans of free market capitalism and would generally argue in favor of tax cuts.
  • But regardless of who wins the debate, history shows tax rate changes have relatively little impact on capital markets.

In an unusual celebration of tax season, politicians are again taking swings at each other over taxes in the name of reducing the US debt and deficits. Now, we don’t happen to agree with either party that our current debt and deficits are an impending catastrophe and view rhetoric over it as largely political. But rhetoric can become policy, so we examine the two camps. (Reminder: We are intentionally wholly politically agnostic in our analysis, finding things to dislike and like in both parties. Cool-headed, rational capital markets analysis should always be divorced from political biases.)

Very broadly, the Republicans have presented a 2012 budget containing spending and tax cuts, while President Obama and the Democrats prefer a plan (heretofore lacking many details) including fewer cuts and tax hikes, particularly on the “rich” (households making over $250,000).

As big fans of free market capitalism and supply-side economics, we’re generally opposed to tax increases on anyone—including the “wealthy,” however they’re defined. The reasons could fill several pages, but consider just the following:

  • The wealthiest 1% isn’t a static group remaining in that lofty firmament indefinitely. Conversely, neither are the lower income brackets. Rather, looking at data, one finds people fairly consistently move up (and down—the one-time sale of a home or business can catapult you one year) through tax brackets over time. So the concept of using tax policy as a redistributive measure to even “imbalances” is faulty at best. (What’s more, we’re not sure what fiscal impact having fewer imbalances achieves.)
  • The group earning over $250,000 annually includes many small business owners and entrepreneurs. In other words, folks who provide jobs, create wealth, innovate new products, and generally help drive economic growth. Increasing Uncle Sam’s cut likely discourages some of that economic activity.
  • Data show in the post-World War II era—through recessions and expansion alike and regardless of tax rates (corporate, personal income, capital gains, you name it)—total tax receipts consistently hover around 19% of GDP, with individual income taxes around 8%.

Regarding the third point: Top marginal tax rates have been as high as 92% and as low as 28% over this time period. That tax receipts have represented such a stable percentage of GDP may seem shocking—until you consider the effect of taxes.

Politicians seem perfectly willing to assert that taxing something begets less of it. So their proposals for curbing what’s deemed socially harmful behavior—whether overconsumption of junk food, smoking, or driving SUVs—is to tax the corresponding input (here, soda, cigarettes, and gas). But many politicians seem equally unwilling to acknowledge the same must be true of income—taxing it at higher rates should result in less income-producing activity than would have otherwise occurred. So either taxes discourage behavior or they don’t—politicians can’t have it both ways.

For many, views on taxes are deeply rooted in ideology and are difficult to change regardless of how much data are presented in favor of one side or the other. So, the good news: History shows markets have a fairly mixed reaction to tax rate changes. Contrary to what many investors believe, tax hikes aren’t automatically bad, and cuts aren’t automatically good. Stocks can and do rise and fall on both. Why? Among other things, US tax policy is just that—US. The overall impact of fairly marginal changes to US tax rates is likely small when weighed against myriad other global factors. While, in our view, big tax increases are an incremental negative for the US, history shows that’s not enough to outweigh other drivers. Capital markets are too complex for that.

So sure, we’d be all for big tax cuts. Not because we think tax hikes are so darn bad for stock markets, but because we believe individuals (like you!) and businesses with profit motives spend their capital far better than an inefficient bureaucracy seeking votes. But we haven’t been asked our opinion as of yet. And we’re not waiting by the phone for Washington’s call.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.