Investment Management. Wealth Management. Financial Planning and Counsel.
Wealth Management. Financial Planning.



Cadinha Blog

Archive

FOR A CLUE TO WHAT’S AHEAD, WATCH THE CBO

We have long been advocates of Supply-Side Economic Theory, which espouses the use of incentives to generate higher economic growth. Unlike the Keynesian view, which depends on government spending and monetary stimulus to provide growth, the supply-side view advocates that growth should come primarily from the private sector.

The supply-side view also expects government tax revenues to increase as a result of higher incentive driven economic growth. Their main incentive?…tax rate cuts! That’s right, in the parlance of Washington news writers, tax cuts will increase tax revenues?? When put in that context it sounds crazy, but history clearly shows that tax revenues actually increase in years following a tax cut. Furthermore, experience tells us that a dollar of “tax cuts” results in 3x (three times) the economic growth rate resulting from a dollar of government stimulus.

Why, then, haven’t we opted for a supply-side solution to our sluggish economy? The quick answer is that immediate stimulus projects are funded with immediate government borrowing, putting more Americans on government dependency. This practice insures more borrowing and greater dependence on government programs by a larger percentage of the population, and while putting immediate dollars in the hands of politicians for spending.

This Keynesian philosophy has guided us over the years to unsustainable levels of debt and increasingly low rates of economic growth. It has become so ingrained in our government that the rules and methods guiding government operations have been shaped into guaranteeing its continuance. As we embark on 2015, there is a spark of hope, however, that could change these fundamentals dramatically. Value pundits declaring that stocks are overvalued could be viewing the same stocks as being undervalued by the end of this year, yet few see this possibility of change.

The Congressional Budget Office (CBO) has been the major point of resistance against all growth legislation. Any such bill affecting the financing of our economy must be analyzed and opined on by the CBO. Any legislation advocating lower taxes or fees is accompanied by a definitive cost or price for such a cut. It is always a cost or price increase because the CBO adopted Static Analysis as the accepted method for their analysis. This has been in place for years, and accordingly, any legislation to cut tax rates or lower fees was met with a cost or price estimate that could only be paid for by an equal spending cut in an already existing program, or another new tax. Those are the rules.

Under Static Analysis, there is no attempt made to quantify the positive results of behavioral change resulting from tax incentives. Instead, these incentives were always deemed to represent “costs” or an additional “price” to be paid by Government. It is no wonder why tax-cut legislation is always met with the question: “How do you expect to pay for it?” It is also no wonder that we have the highest corporate tax rates in the world, and why when measured against after-tax profits, current stock prices appear high to many.

Yet, from the “inside” financial pages, we gain encouragement from the fact that the new Republican Majority is asking the CBO to change their scoring method to include the behavioral positives coming from tax incentives. Apparently they are even willing to remove the head of the CBO if they do not change to Dynamic Scoring. With such a change at the CBO, the odds of a corporate tax rate cut increase dramatically. We must remember that President Obama has often said he favors a lower corporate tax rate, but that he differs on how to “pay for it.” With a CBO scoring change, that arguable difference could become moot.

When discussing tax rates, the President has advanced a 28% corporate tax rate as being acceptable, while the Republican leadership is advocating for a 25% corporate tax. Both opinions represent a significant cut from the present 35% rate. For a company currently paying a 35% tax on gross profits, the President’s 28% rate will increase net profits by nearly 11%! The Republican rate will increase profits by 15% for the same company. Upon passage, supply-side economists would project corporate capital expenditures to increase dramatically, leading us to higher economic growth rates. This is why many Wall Street strategists could be “off the mark” this year. If this story “has legs,” we expect the market to respond favorably as soon as it hits the front page.

Positive tax legislation will likely provide more upward pressure on an already strong dollar, bringing deflation to commodity prices. Earnings for companies producing commodities and companies with a high percentage of foreign earnings will be under pressure. We will still continue to underweight these sectors and carefully watch the CBO news.

Credit issues and risk of default will intensify with further dollar strength. Lower quality bonds issued by commodity producers and foreign “dollar” borrowers will become increasingly risky and should be avoided. We believe there are more than five trillion dollars involved in overseas lending, and if the dollar strengthens further, it could spark a sudden calling of these loans and a flight of capital from lesser developed countries to the U.S. This could in turn trigger a further spike in the dollar with dire global economic consequences. Clearly, we want to stay clear of and monitor this type of risk carefully.

Lastly, to provide an analysis of Ebola, Iran, ISIS, the Ukraine or a recession in China is probably fruitless at this point. No one really can foresee the related “ups and downs” coming. We feel confident in our view, however, that a stronger dollar will not diminish geo-political risk, but rather, serve to increase it. As we would advise anyone on the eve of a stormy night…stay at home.

After all, there’s plenty of opportunity in our own back yard. All of us at Cadinha & Co. wish you a healthy, happy and prosperous New Year.

About the Author


Harlan J. Cadinha
Founder, Chairman and Chief Strategist
×

ARCHIVE

BY CATEGORY

BY DATE

Older Posts
Back to Blog



More on worth that’s worthy of your time. Sign up for our newsletter.