Moving Past the Election

By Charles Webb

There has been no better evidence around here of the importance of this  year's presidential election than the number of phone calls and emails received after the election from worried clients questioning the economic impact of the results. The post-election thousand point drop in the Dow Industrial Average was another good indicator of the market's uncertainty. The two big questions the election has raised, or maybe not put to rest, are about taxes and the deficit, both of which are encapsulated in the drama surrounding the looming fiscal cliff. We've written extensively this year about all of these issues but we think a recap of those points is in order anyway.

The fiscal cliff is the popular shorthand term used to describe the decisions Congress must make come December 31^st regarding the expiration of the Bush era tax cuts and the scheduled spending cuts set to take effect in January. In 2010, Congress kicked the issues down the road by extending those tax cuts through 2012 and postponing any spending cuts until then as well.

The serious questions about spending and taxes were raised in 2010 because of the massive annual deficits which began in 2008 and have since run well in excess of a trillion dollars per year. The weak condition of our economy two years ago gave cover to the politicians in Washington to postpone any hard choices until now.

Two years later, the economy is in better shape than it was but is far from healthy. The most contentious part of the debate revolves around tax increases. We already knew that taxes on investments were going up with the implementation of the new healthcare legislation. Under that, investment income for those making $200,000 and above is going to be subject to Medicare taxes (3.8%). In addition, the president would like to see the tax rate on dividends and capital gains be subject to the ordinary income tax rate for those same individuals. Furthermore, he'd like to see the top ordinary tax rate raised by several percentage points. The combination of these proposals represents a substantial tax hike on investments and capital formation. For the record, we think this is a terrible idea.

We disagree with these proposals for a number of reasons, some philosophical and some economic. However, the primary reason is that we see big tax hikes as having little impact on fixing the deficit but likely adding substantial risk to the economic recovery. As we've noted before, our annual deficits have averaged roughly $1,300 billion ($1.3 trillion) per year for the past 4 years. A lot of that has been blamed on tax receipt shortfalls from the economic meltdown that began in 2008. While that may have been true in 2009, it certainly isn't now.

Year	Tax Receipts	Outlays	(Deficit)
2007	2,568	2,729	(161)
2008	2,524	2,983	(459)
2009	2,105	3,518	(1,413)
2010	2,163	3,456	(1,294)
2011	2,304	3,603	(1,300)
2012 Est	2,468	3,796	(1,327)

 

 

 

The above table shows tax receipts and expenditures in billions of dollars over the past half dozen years. You can clearly see the fall off in tax revenues from 2007 to 2009. You can also see that this year's estimated revenues are within $100 billion of 2007. It's important to note that in 2007, we had the highest level of tax receipts ever. The expenses are clearly the problem and should be the primary focus of the debate. 2012 expenses are projected to be $1,000 billion ($1 trillion) higher than they were back in 2007. It's hard to see how raising taxes will contribute in a meaningful way to put our country's fiscal house in order. The highest projection we've seen of the proposed tax increases is $120 billion. This, by the way, is if all the proposed tax changes were enacted and those tax payers being hit by them made no changes in response. How likely is that? Not very. A more realistic estimate is about $70 billion. That would bring this year's deficit down from $1,327 billion ($1.3 trillion) to $1,257 billion ($1.3 trillion). That doesn't even affect the rounding.

At the risk of beating a dead horse, this is the third time this year that we've presented these statistics. But we feel it's important to keep pressing this point. This problem won't get fixed until it is honestly addressed. The buzz word constantly thrown around in the fiscal cliff debate is "balanced" - meaning a solution will require both tax increases and spending cuts. In our minds, if the solution were to be truly balanced, we'd have to have 10 dollars in spending cuts for every 1 dollar of tax increases. Rest assured that there haven't been any proposals that resemble those figures.

There's a lot of talk about having to make changes to Social Security and Medicare to balance the budget. This is certainly true long-term, but those programs are not responsible for over $1,000 billion ($1 trillion) of additional spending per year since 2007. The budget would be balanced this year if spending was simply reduced to where it was in 2005. That was also at the height of the Iraq war. You have to ask yourself what in the world has changed in seven years that has necessitated an additional $1,200 billion ($1.2 trillion) of spending? Well, for starters we've had cash for clunkers, cash for caulkers, cash for first time home buyers, cash for high-speed rail, cash for solar, cash for wind energy, cash to help buy electric cars, cash to develop electric cars, cash to build the batteries for electric cars, and on and on and on.

Here's a more specific breakdown by category of where our tax dollars go. Ironically, the smallest percentage increase has occurred in pensions, which is Social Security. The next smallest percentage increase was in healthcare, primarily Medicare. From there, it's a who's who of government agencies and programs. The "Other" group sticks out with $200b in spending. Some of the big items in there are: Freddy and Fannie Mae Bailouts 40b, FDIC Insurance - 27b, Farm Support - 26b, TARP - 19b, NASA - 17b, Land Mgt - 12b, Green Energy - 10b, Pollution Ctrl - 10b.

Outlays By Category in Billions of Dollars
	2007	2012	Chg	% Chg
Pensions	628.3	819.7	191.4	30.5%
Healthcare	641.8	846.1	204.3	31.8%
Education	100.8	153.1	52.3	51.9%
Defense	652.6	902.2	249.6	38.2%
Welfare	262.1	451.9	189.8	72.4%
Protection	42.4	62.0	19.6	46.2%
Transportation	72.9	102.6	29.7	40.7%
Gen Govt	19.8	33.6	13.8	69.7%
Other	71.0	199.6	128.6	181.1%
Interest	237.1	224.8	(12.3)	-5.2%
Total	2,728.8	3,795.6	1,066.8	39.1%

 

 

 

 

 

 

One of the more interesting items here, and we think the most noteworthy, is interest. This gives you a pretty good indicator as to how much of a budget buster interest rates will be in the future. As we've stated before, the outstanding debt has risen roughly $6,000b ($6 trillion) between 2007 and 2012. Yet the interest expense has declined. That shows how far interest rates on Treasury bonds have fallen. If rates were currently where they were in 2007, interest expense would be approximately $380b. That's over $150b higher than it is now and would consume more money than all of the proposed tax increases combined.  

In addition, the government has been financing its deficits with short-term debt in order to take advantage of these super low rates. This is not unlike what subprime borrowers did with their homes a few years ago. Just like those borrowers, the government is going to see its interest cost skyrocket when rates head higher and they have to refinance all of those bonds coming due. Every one percentage point increase in interest rates on $16,000b (16 trillion) of debt would add an additional $160b per year of spending. The current yield on a 10 year treasury is almost 3 percentage points below its normal rate. There's only one reason rates are this low - the economy is in poor health. If you think the economy is going to get better, rest assured rates will return to their normal levels.

Earlier this year, I heard the president field a question about how concerned he is about the nation's debt. He replied that it was a concern longer term but in the short run it's not a big deal because rates have been so low. In my mind, that's a little like having a gun fired at you and thinking that it wasn't a problem because in the short run, the bullet's not here yet. It's ironic that our government is behaving exactly the subprime borrowers that got us in this mess in the first place.