"Markets can remain irrational longer than you can remain solvent."
John Maynard Keynes
Currently, the price earnings ratio for the S & P 500 is 28 times trailing twelve months earnings. This valuation is far above the historic median of 16 times. The rich valuation reflects a willingness on the part of investors to overlook obvious threats to both economic stability and corporate profits. Investors seem to be steadfastly focused on near-term events while the primary threats to economic stability are likely to have an impact on stock prices over the long term.
Most of the challenges facing investors and policy makers are familiar, but some are new. The Federal budget deficit is large, it is estimated to be $1.9 trillion in 2024. The Congressional Budget Office forecast calls for the deficit to grow to $2.5 trillion within five years. While the budget deficit has grown, The Federal Reserve has set a 2% target for inflation, and it has raised short-term interest rates to achieve that goal. The higher rates are an obstacle standing in the way of continued economic growth. Should the Fed choose to monetize a significant portion of the looming deficits, its goal of managing inflation will be difficult to achieve. Once the Gold Window was closed in 1971, the Fed often did not hesitate to help finance the deficit. If the past policy choices are repeated it is likely inflation will become a problem once again, and the Fed will raise rates and threaten economic growth once again. The large and growing deficits and the Fed’s efforts to control inflation in the face of these deficits are well known threats to economic stability.
Changes in the tax code proposed by both parties as part of the 2024 election campaign are the newest threats to both sound economic progress and the stock market’s performance. Among the changes the Democrats have presented are increases in tax rates for corporate profits, increases in tax rates on investment returns, and increases in tax rates on personal income. In addition, they have proposed providing rewards to first-time home buyers, and an increase in the Child Tax Credit. Most prominent among the proposals advanced by the Republicans are increases in tariffs on trade with other countries.
It is not certain any of the changes in the tax code will materialize in their current form or in any form. Proposed changes must survive the legislative process, and the outcome of that process cannot be foreseen at this time. However, it is important for investors to begin to anticipate changes in investment strategies to reflect a changed tax regime.
The thrust of the Democrat’s proposed tax revisions is to increase tax rates on personal income, corporate income, and savings and investment. If the revisions come to fruition the highest tax rate on personal income will rise from 36% to 39.7%, a 10.3% increase in the tax rate. The tax rate on corporate income would rise from 21% to 28%, a 33% increase in the tax rate. The highest tax rate on long-term capital gains would rise from 20% to 28%, a 40% increase. The tax rate on estates would increase substantially. Among the most controversial of the tax rate increases proposed by the Democrats is a 25% tax on unrealized capital gains. These proposed changes will result, likely, in lower corporate profits, below average economic growth, and a reduction in the valuation of stocks.
Absent from these proposals is an understanding of the nature of tax incentives. Corporations do not pay taxes; they collect them from their clients and their employees. Raising the tax rate on capital gains raises the cost of capital and reduces the incentive to invest. Increasing the tax rate on those with a high marginal propensity to save and redistributing it to those with a high marginal propensity to consume reduces savings and investment. The proposed changes will raise the incentive for capital to move to regimes with lower tax rates.
In the long list of proposed revisions advanced by Democrats is a $25,000 tax credit for first time home buyers and an increase in the Child Tax Credit to $6,000. The home buyer tax credit will increase the demand for new homes, all other things being equal, without increasing the supply. The recent decline in new home prices might be reversed if demand rises. The increase in the Child Tax Credit will stimulate demand as the Fed is trying to control inflation.
The Republicans have proposed an extensive list of revisions to the tax code as well. The most controversial provision is an across the board 10% tariff on imports, and a 60% tariff on all imports from China. The Republicans want to extend the tax rates put in place in the 2017 Tax Cuts and Jobs Act, TCJA. The TCJA tax rates are below those proposed by the Democrats in every instance. For example, under the TCJA set of tax rates the tax on an estate of $15,000,000 or below would be zero. The Democrats would increase the taxes on a $ 15,000,000 estate to $4,400,000. The Republicans have also a proposed reduction in the corporate tax rate to 15%. While the Republican’s proposed tax schedule appears to be consistent with favorable growth rates for the economy and corporate profits, some analysts believe the tariff provisions will negate the positive effects of lowered tax rates.
At this point in the election cycle, the proposed set of tax revisions are not structured to stimulate real economic growth or tame inflation. There is now a high probability the environment for the next few years will be more like that of the 1970’s rather than that of the 1980’s. During the 1970’s, tax rates increased, tariffs increased, inflation increased, regulations increased, and economic growth ended. The stock market generated a -1.4% annual real return in the decade of the 1970’s. After the election of 1980, policies were enacted that reversed the trends of the earlier decade; tax rates were lowered, inflation was controlled, and regulations were reduced. As a result, economic growth resumed as did the growth in corporate profits. In contrast to the 1970’s, in the 1980’s the stock market produced an annual real return of 11.6%. The 1980’s were the beginning of a more than 40-year bull market in stocks.
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