SunLakes of AZ Blog

Using Open Source for work and play

July 2017

Happy Day-After-Tax Day

by Karl Schroeder for Finance

Tax day comes and tax day goes with nary a whimper from the citizenry. This is the way it works in the modern economy. Were it not for the anesthetic of regular withholding the situation might be a lot different. Think how bad things would be if each of us had to put aside sufficient funds to meet our tax liability each year. If you had to set aside 25% of your ready cash for the day, once a year when you had to write that big fat check to the government, then each pay day or each month when you went through the exercise you’d be reminded just how little you get for your money. The resentment would undoubtedly be much higher among the somewhat more than half of Americans who actually pay taxes toward the other half who generally receive more in government largesse than they pay in taxes. The resentment toward the government itself for its profligacy, waste and abuse would likely be higher, too. We’d have more limited government is our guess, but we could be wrong. Maybe a lot of people would gladly put aside 25% of their incomes to help the needy, to provide for police, fire and national defense, for libraries and schools, for roads and sewers. Sure they would.

Withholding was begun during World War II in order to accelerate the cash flow to the government to pay for the war effort. It never went away after that. Between withholding and estimated tax payments, taxpayers are supposed to pre-pay at least 90% of their ultimate tax burden before filing. That’s bad enough, but most of us are over-withheld. The interest-free loan to the government makes for a huge subsidy to the tax man. But, the worst of it is that we all have come to think in terms of ‘take-home pay’ or ‘after-tax’ pay rather than gross wages. For those of us who get a paycheck and do not have to ability to forestall recognition of income, withholding is a regular reminder that we are vassals of the state. Here is where all our right-wing friends cry “hear, hear” or “yeah.”

Our guess is that were it not for withholding the incentives to not recognize income and not pay taxes would make tax-cheats out of most of us. Back in the bad old days of the 1970s, it was estimated that 10% of the US economy was ‘underground’ to avoid taxes. That brake job that was advertised as $100 an axle would suddenly become $80 an axle if you were willing and able to pay in cash, preferably small bills. Tax rates were much higher than today, or even next year, until the Reagan tax cuts in 1981 and 1984. The highest marginal tax rate was 70%. At that rate, it was worth it to cheat. Taking our brake job example above, if the cost of delivering the fix was $50 the official brake job would net the owner of the shop maybe $15 ($100 minus $50 times 30% (the residual of the tax rate) equals $15). By cheating, he would retain $30 ($80 minus $50 equals $30 and none to the tax man).

A big part of the rationale for lowering the tax rate was to stop the rampant cheating. The argument went that people would pay a tax they viewed as fair and equitable. As usually happens when tax rates are cut, tax receipts went up with a stronger economy and less widespread cheating. Along with direct cheating, many people employed legal, or presumably legal, tax-advantaged strategies. Any area that was tax-advantaged (think single-family home with tax deductible interest and taxes) did reasonably well. Areas that were able to show big tax savings would attract money. Tax shelters were sold on all sorts of items, apartment buildings, oil wells, freight cars, you name it. If you could separate the tax deduction from the production of income, you had a tax shelter. You don’t see many of those any more. Taxes are just too fair.

That brings us to the issue that many of us have largely forgotten about. Our tax rates are going up next year and we probably can’t do a thing about it. The Bush tax cuts of 2001 included a sunset provision so that in the arcane math of the federal bureaucracy they wouldn’t raise the deficit over time. The revenue raised after the taxes sunset would partially offset the lower revenue while the tax rates were in place. So, your tax rates are going to revert to the levels of the late 90’s. Remember the late 90s? We actually had budget surpluses in the late 90s, thanks to a vibrant economy, low unemployment and the biggest non-wartime tax increase in American history. Don’t think for a minute that we’re headed back to those halcyon days. Surpluses are now only a fading memory. Something you’ll tell your grandchildren about, like the tooth fairy.

Our taxes are going to go up next year and that probably will have some modest negative impact on the economy, but it will be so broadly spread and so hard to measure that we won’t really notice. Don’t expect a simple shift from a highest marginal tax rate of 35% to 39.6% to matter to anyone. Sure the fat cats will have to pay more. Wait a minute; they probably won’t pay any more than they want to. They can use tax shelters and delay income recognition to lower their tax burden, just like they always have. The rate will go up, the brakes will drag a little bit on the economy at large, so we won’t get any more revenue unless we create more jobs, create more income and thereby create more wealth.

Tax rates should be fair. When they are, people pay their taxes and go about their business. When they are not, it doesn’t work the same way. Reagan was right, again.

Crisis of the Week

The potential for a ‘hung Parliament’ is sort of a lame crisis this week, but its about all we’ve got. Sure, there were terrible earthquakes in China, but that has limited impact on the financial markets. Goldman getting sued could become a crisis someday, but not yet. A seriously wounded United Kingdom would be another thing altogether. Unlike here in the US, most European countries have multiple political parties. We have Republicans and Democrats while the Brits have Labour, Tories and Liberal Democrats. There is a pretty good chance that in their upcoming election, none of the three parties will achieve a clear majority in Parliament. The odds favor the Tories (conservatives) winning the most seats in Parliament. Polls give them about 40% of the vote, which would translate into more than 40% of the seats. Labour is next with roundly a third of the voters and then the Lib Dems with about 20%. A grab-bag of smaller parties and regional parties take up the remainder. (There is still a Scottish separatist party that wants Scotland to secede from the United Kingdom and go its own way.) The Tories could win enough seats to have an absolute majority, but it looks more like Labour, in coalition with the Lib Dems, might be the next government. The Lib Dems see more eye to eye with Labour than they do with the Tories. Since Parliament elects the Prime Minister, that would mean that current PM Gordon Brown, might keep his job, but he’d have to give several ministerial jobs to Lib Dems. This would mark the first time that Lib Dems would serve in government.

Why is this a crisis? Well it isn’t yet. It’s a risk that Britain faces. But, with a relatively slow news week, it was a good time to reflect on what it might mean.

First, we would not get any of the party platforms pushed in Parliament, only watered-down versions of the areas where they can agree and then only by counting every vote on every issue. This might easily mean that Britain would not make some of the very important decisions they really need to make to turn-around the economy there. They have at least as many crises stewing as the US does and even if you don’t like the direction of US policy, we at least have a policy that the majority in Congress (the opposite of progress) wish to pursue. You don’t have to like what is going on to recognize that at least something is going on. With a hung Parliament, you wouldn’t necessarily get anything done. Anything.

This might not be all bad. It might be the best solution to the problem, or the worst. But, then it is likely to be a very temporary solution. The most likely response to a hung Parliament would be another election as soon as the polls indicate that the voters had had their fill of Parliament doing nothing. Labour could call for elections at the first chance to improve to a majority, or a no-confidence vote over the most trivial issue could bring down the government on a moment’s notice. Either way, it would probably lead to another election within a fairly short time period.

The markets in Britain are presupposing a Tory victory. The Tories (the party of Margaret Thatcher and the rebirth of Britain as an economic player on the world stage) would be a natural response to the Labour government’s loss of public trust.

As we have mentioned before, this is an unusual situation in Europe as France, Germany and Italy all have center-right governments these days, while Britain’s government is leftist. As such, if current economic policies fail to resuscitate growth, other European nations can move to a more populist or socialist answer to the problem. Britain is already at the socialist end of the spectrum and will either stand still or move rightward. That could be interesting.

Economic News

Our Trade Deficit expanded in February. The change was driven by a surge in imports. Part of the difference could be our pace of advance versus that of our trading partners. If we are growing faster and earlier than they are, demand for our exports will rise more slowly than our demand for imports. Or, it could just be that we’re a bunch of happy spenders who want more stuff than our economy can produce.

Consumer prices rose in March at a 0.1% rate. The core version of the index, which excludes volatile food and energy components, was unchanged last month. Energy prices generally fell (which does not make a lot of sense to your pundit) but food prices rose. As we have been predicting, inflation will be a problem someday, but given the low level of factory utilization and high unemployment, it is not a big problem today. Take that people in TIPS!

Retail Sales rose by 1.6% in March, much more than expected. The gain was centered in autos and building materials, but sales ex-autos also gained 0.6%. This is the fifth gain in six months and part of a gain of over 7% in the past year. For those who thought the US consumer would sit out this recovery, all we can say is HA!

Industrial production rose in March after weather dented reports in February and January. The gain was well below forecasts but still positive. Reduced output from utilities offset a strong showing from factories.

Housing starts gained for the third straight month. That doesn’t quite sound right, does it? No, the original report for February was a significant decline in starts. Now that has been revised away and February actually had a modest gain in starts. The March level, at first blush seems to fall well short of expectations, but when we revise those expectations to reflect the February revisions, the actual pace is comfortably ahead of where most economist thought we were. Confusing? You betcha.

Consumer Sentiment, somewhat surprisingly, fell in early April. The guess was for a small increase in sentiment due mostly to the first rise in jobs in over two years. Instead, we got a small drop to 69.5 from 73.6 instead of the rise to 75 we were guessing. Those wacky consumers!

Weekly Stuff

Okay, we got the S&P 500 through 1200 last week and the NASDAQ above 2500, so the bull market continues with hardly a whimper from the broad media. There are no cover stories in People or Time magazine about how great the bull market is. The rally is starting to be believed by the individual investor, but only barely. Then bang, Goldman Sachs gets hit with fraud charges, stemming from sales of derivative securities back in 2007. We don’t know if this suit has merit or if it is just the SEC trying to win some credibility after the botch it made of regulating Wall Street during the heyday of the last bull market, but the aura of quiet that had permeated the market is suddenly gone.

Let’s review our definition of a bull market – a protracted period of time when the market generally advances, putting-in higher highs and higher lows, but punctuated by short, sharp corrections. We seem to be headed for one of those short, sharp corrections right now. We’ve had the higher highs and higher lows over the past year-plus, now comes the test. We had become complacent. We had just become somewhat bullish. So we were ready for a correction. Had we not become complacent, had we not become bullish, this sudden shift in fortune wouldn’t have been so upsetting, just more bad news.

There will be more on Goldman and other brokers in coming days, this might even make it into the Crisis of the Week if they’re lucky. But, the world goes on regardless.

For the week, US stocks were generally higher, with the S&P 500 showing a small loss but the small stocks, the NASDAQ and the Dow making gains. We are just getting into the core of earnings releases with the numbers coming fast and furious this week. By and large, the numbers are expected to be good, but we should see some great numbers as well. Heaven help you if you disappoint now.

Foreign stocks were largely down. The EAFE made a small gain, but when we looked virtually all the markets that make up the EAFE were down. The dollar was up and the markets were down, sounds like the EAFE should have been down. We’ll see what that means, if anything at all. The emerging markets were down as well, with Brazil taking it really hard. Latin America was the worst area but few leading emerging markets were spared.

It was a good week for bonds, with the return of risk to the markets (at least the reappearance of risk in the form of the surprise meted to Goldman). Many of the risk trades are being reversed. Oil was down and bonds were up, gold was down and bonds were up, many stocks were down and many bonds were up. Yes, risk seems to be back and bonds are again a safe haven. Most parts of the bond market joined in the good times with corporates and Treasuries, munis and mortgages all gaining.

Foreign bonds also improved, but the benefit wasn’t widely distributed. Many emerging market bond markets were caught up in the unwinding of risk trades and fell. Most developed markets were gainers.

Real estate securities were generally down. As they have done frequently over the years, real estate follows the lead of financial stocks. With financials getting whacked, so too did real estate securities. The news of a Morgan Stanley Real Estate fund announcing a huge loss for its investors surely didn’t help. This fund, which is unrelated to Morgan Stanley’s real estate securities team, raised money from pension funds, endowments and rich individuals to buy specific properties. The fund, launched near the height of the real estate bubble, used modest leverage and owned over $20 billion in properties with an original equity stake of $8.8 billion. That equity stake took a $5.3 billion hit with falling real property values. Ouch! 

We should remember that headline risk was one of the areas that we felt would befuddle real estate investors after the huge run-up in REIT prices over the last year.

Commodities displayed small gains in the indexes even with losses in crude oil, gold and other high-profile commodities. Gains in nickel, some agricultural commodities and some softs were enough to propel the Dow Jones index higher. The GSCI fell due to the drop in energy prices.

Have a great week.

Karl Schroeder RFC, CSA

Schroeder Financial Services, Inc.

Investment Advisor Representative

480-895-0611

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