A Tax Barbell
David R. Kotok
Cumberland, January 10, 2013
Washington has handed an economy now struggling to get back on its feet a barbell instead of a helping hand—a tax barbell. With much hoopla and political posturing, the United States’ political leadership raised the income taxation on the “rich,” as the White House likes to call them. But without a word, the White House and the Congress also raised income taxation on the working poor and lower middle class. That is the effect of the payroll tax (2%) hike.
We believe the impact of this tax increase will be a lower economic growth rate for the US than would have been possible if no income tax rate and no payroll tax rate changes had occurred. How much slower is subject to debate, but nothing in the so-called Taxpayer Relief Act affords an iota of relief to anyone who works.
Let’s focus on the lower end of the income scale, the working population with incomes in five figures. In our view these taxpayers were hit hard. Since most of their incomes are spent on non-discretionary consumption, they will likely invade savings or lower their savings rates in order to sustain themselves. Collectively, they have been hit with a $120 billion annual tax hike. That is nearly $1000 for every working person in America.
An analogous situation might be a spike in the price of gasoline. Let’s use that to demonstrate the impact of the payroll tax.
Suppose the price of gasoline jumped from $3.50 per gallon to $4.50 in one day and stayed at $4.50 for an entire year. How would we react as Americans? We would see the price at the pump as a continuous reminder of the change in our circumstances. We would witness the nightly news reporting this change. We would be livid with politicians, clamoring for them to act. Those are the same politicians who were silent a few days ago.
The essence of the question is Americans’ behavioral response to a change in economic circumstances. Are we going to see it 2013? The macro numbers would say the answer is yes. Roughly, a penny per gallon change in the gasoline price equates to about $1.2 billion in consumption expenditures per year for American consumers. If we have just imposed a two percent tax on the earned income of most Americans, we have essentially imposed the equivalent of a gasoline price hike of $1 per gallon.
What this taxation change means is that the growth rate of the US economic recovery will be slowed measurably. There are models which incorporate the economic growth rate, the population change, and the labor force participation rate. Put them to work, and the result of this barbell taxation is to extend the period needed before the US economy will reduce the unemployment rate to the Fed’s target of 6½%.
In other words, President Obama’s noisy attack on the rich also silently punched out the working poor. But Obama did not do it alone. The Democrats and the Republicans in the House and the Senate were complicit. How many did we hear or see defending the working population whose incomes are $100,000 a year or less?
Robust recovery is now less likely in the near future. That is especially true because of the abject failure of the White House and Congress to extend, or make permanent, the 2% reduction in the payroll tax.
Cumberland continues to expect a slow, gradually recovering economy. That will continue for a number of years. Interest rates will remain low, although they may be volatile, as we can see in the bond market’s response to the Federal Reserve minutes. That structure is bullish for the US stock market. Bond portfolios can use hedging techniques to mitigate some of the volatility in interest rates.
Also note the Labor Department estimates of about 460,000 folks counted as employed because the states are paying subsidy to keep the jobs rather than have the person seek unemployment benefits (source: Bloomberg, January 10). The effect is to distort the reported unemployment rate downward because those folks remain “employed”. We are not opposing the policy. We are just noting that the Fed’s target of a 6 ½% unemployment rate may need to be examined for these changed circumstances which are not in the historical data. This revelation is additional support for our view that the period of low interest rates and ongoing Fed QE policy is longer than markets currently expect.
We are scheduled to appear on Bloomberg TV with Trish Regan for the whole hour on Tuesday, January 15 from the 3 to 4 PM (EST). We hope to discuss this reduction of growth due to taxation and what it means for the extended period of low interest rates.
David R. Kotok, Chairman and Chief Investment Officer