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THE COMING TAX BOMB

My colleagues and I have always believed in proactive investing. This practice is grounded in macro-economic analysis and involves projecting that analysis into the future. To effectively do this, many considerations must be put into the equation and weighed as to probability. Most often politics, currency values, central bank policies, and regulations are the key considerations that effect change; however, there are many others which become important from time to time.

Over the years, our process has worked well and has most recently allowed us to anticipate the current credit crisis, sidestepping the damage created in the financial sector, and protecting assets in the process. Because this financial crisis is now well publicized, everyone is becoming aware of the increased risk in the financial sector. To our way of thinking, this probably means that the end of this crisis is near. Accordingly, we are now contemplating the future and assigning probabilities to various possible scenarios.

Unfortunately, the scenario that seems to be the most probable centers on changing government policies with respect to taxes and regulation. There is one certainty, however, and that is the expiration of the Bush tax cuts. This expiration will increase marginal income tax rates across all brackets.

The highest income payees will experience a 13% increase, while lower income households could see their rates increase by 50%. The marriage penalty will be re-established and the child tax credit will be cut by $500 per child. The long term capital gains tax rate will increase by 33% and the tax rate on dividends will go from 15% to 39.6% (an increase of 164%). Lastly, the death tax will bounce back from the dead (pun intended) and be reconstituted at 55% with an exemption of only $1,000,000.

Clearly, this expiration will likely cause serious economic and stock market damage. Let me use an example to explain this. If, after taxes, your income from an investment is cut by 30%, what will likely happen to the value or price of that investment? One should expect the value of the investment to also drop proportionately. This is exactly the effect that will be created by the increased tax on dividends. In aggregate terms, the value adjustment for the stock market should be similar in magnitude.

This, I realize, is an over simplification, but clearly the effect of this tax increase on dividends is not positive for stock prices. Now let me ask: If you believe that there will be a downward adjustment to stock prices next year and you also anticipate a 33% higher capital gains tax rate next year, what action do you take before the political change in Washington? You bet…Sell! This is likely to be the attitude on the eve of expiration, which is slated for December 31, 2010. Earlier repeal would simply accelerate this discounting process.

The election season has brought forth some interesting proposals from candidates: There is a proposal to lift the “cap” on wages eligible for the 12½% FICA tax. This proposal will increase the tax on any wage in excess of the present $103,000 cap. Combined with the expiration of the current 35% tax rate, this proposal will raise the effective upper marginal rate to 54% (if you include the 2% Medicare premium as a tax). -more-

  • Another proposal advocates a 5% surcharge on adjusted gross income. Since capital gains and dividend income is included in adjusted gross income, a portion of these types of income can be taxed at 40%, and after the expiration of the Bush tax cuts, the top tax rate moves to 45%.
  • Currently, the U.S. taxes foreign-sourced corporate income as the money is repatriated back to America. A credit is currently offered for foreign taxes paid, but a new proposal ends the deferral of U.S. taxes paid on foreign revenues. Companies will be forced to pay the difference between foreign taxes and the U.S. 35% tax rate, even if the money never re-enters America’s borders.
  • A few in Congress are mulling over a value added tax, as a revenue enhancer designed to satisfy the protectionist sentiment in Washington. Additionally, an excess profit tax on oil producers has also been suggested.
  • The increase in the capital gains tax could be greater than that realized through expiration of the Bush tax cuts, as one candidate is advocating an 87% increase in the capital gains tax rate.

The stimulus package of $150 billion, combined with the economic slowdown nicely sets the stage for a higher budget deficit. Instead of advocating higher growth, the politicians will likely increase tax rates as a solution, which in turn will curtail growth and increase the deficit. We expect the election results to be in favor of the Democrats in Congress and the Senate, and consequently, one should expect the tax bomb to hit in early 2009. The actual timing, however, will depend on who is elected to the White House. Tax increases can be achieved through the budget reconciliation process, and need not be subjected to a filibuster.

Investors who see this ticking tax bomb will likely sell in advance of higher taxes, while entrepreneurs who see higher income tax rates coming will likely advance income while income tax rates are lower. The immediate effect will be higher tax revenues and stronger economic numbers than expected, as some of this advanced income will undoubtedly be spent on consumption.

The proponents of higher taxes and bigger government will likely not experience the increased tax revenues as promised because tax avoidance behavior will once again deny them these monies. If this analysis is accurate, one might expect a milder than expected slowdown this year, with the damage from the tax bomb hitting later. A rally in the stock market and dollar this summer would be in keeping with these conclusions, but fears of a tax explosion will likely take over as the election rhetoric heats up. Investors need to be somewhat schizophrenic at this time, identifying and investing in those great companies that are at bargain prices while looking over their shoulders for signs that the market may be showing concerns about the changing tax structure of our society.

About the Author


Harlan J. Cadinha
Founder, Chairman and Chief Strategist
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