By Jim Miller

Obviously I'm using a play on words when I say "taxageddon" but, by no means, is this a laughing matter to all of us Americans who who actually pay Federal income taxes each year.    

I came across an interesting statistic a couple of weeks ago in the Wall St. Journal comparing tax revenue in the 1960's to the modern era.  According to the U.S. Bureau of Labor Statistics, back in 1965, approximately 88% of all working adults paid some form of Federal income tax and roughly 1/3 of all American adults during that same year were on some form of government aid (i.e. Social Security, Medicare, Food Stamps, etc...).   

In the year 2012 only 53% of U.S. working adults are paying Federal income tax.  At the same time, slightly more than 50% of all American adults are currently receiving some form of government welfare.   That is a significant transformation.  Meaning,  back in 1965 there was, roughly, 2.7 taxpayers supporting 1 person on government aid.  Today, the ratio is essentially 1-to-1. 

The Dilemma  

As you've probably heard by now, the Bush tax cuts, that originally went into effect back in 2003, are set to expire on December 31, 2012 if Congress decides to let them sunset or expire.  You may remember that the Bush tax cuts were originally set to expire on December 31, 2010 but President Obama and Congress passed an extension in the 11th hour to extend the cuts through to the end of this year.

If the U.S. government decides to do nothing, this time around, as you'll see from the table below, the Federal tax code will revert back to the old marginal rates of 2002 and will, in my opinion, not bode well for investors who have large exposure to stocks.  

Why do I think this?  Historically speaking, whenever a government increases the tax withholding on dividends and capital gains (two separate taxes) they marginalize the incentive for investors to add more money to stocks.  In turn, the money inflow that global investors would have put into stocks declines and investors find other places to park that cash (i.e. bonds, money market, real estate, etc...).   Remember, money is always working 24 hours a day and has to reside somewhere.  If not in stocks, investors will find other places to put their money to work. 

The same dynamic happens when interest rates rise - which we are also likely to see in the next 1-3 years due to the hyper-rate our Federal Reserve has been printing money into the economy.   

As an example of what I'm talking about, assume interest rates on a 5 year CD jumps from 1.75% to 3.75% in a year.  Now, in my hypothetical, a retiree can get almost 4% guaranteed by the full faith of the U.S. government rather than roll the die by investing it in the stock market.  Which option do you think retirees will choose more times than not?

It's basic supply and demand at play here.  Like any free marketplace, if you increase price (or in this case the tax of the product) you will negatively impact demand for that product or service.      

Understanding The Elasticity and Demand For Stocks

There are a couple of economic terms that you should understand when analyzing this issue.  In a free market you have goods and services that have price elasticity (a rise in price causes a decline in demand) and, inversely, price inelasticity (a rise in price has little to no effect on demand).   

While I am simplifying a much more complex issue, at it's core, an example of a price elastic good would be a cup of coffee in the morning.  If the vendor (i.e. Dunkin' Donuts) decides to raise their cup of coffee from $2.50 to $3.50 they will most likely see a decrease in demand for their coffee as some of those customers will go elsewhere for their cup of Joe.  Unless, of course, all coffee retailers raised their prices together not providing the consumer any choices.  However, this is known, in economic parlance, as collusion and is considered illegal by the Federal Trade Commission (FTC).  I'll save that discussion for another time.   

So, back to the topic at hand.  An example of a price inelastic good or service is something that is a necessity to the consumer in his/her daily life such as food staples and water.  Thus, even if prices rise we (the consumer) will most likely continue to buy that good or service because we need it or perceive that we need it.  I do not believe that I'm going out on a limb when I say that stocks are not a necessity for most of us in our day-to-day lives and are price elastic.  

In summary, now that we've established the fact that stocks are price elastic, what does it's elasticity have to do with stocks?  Simple.  If the government raises the tax rate on dividends and capital gains tax, the cost of investing in stocks will have just become more expensive for all of us.  If the returns for stocks do not rise proportionately to the new tax we are paying, we (the investor) have less in our pockets at the end of the year.  Considering the intrinsic risk (one of the highest of all assets) that investors must assume when investing in stocks higher taxes are not a good thing!  

How Bad Could It Be? 

I've provided below, from our good friends at the ISI Group, a table that shows you what the tax rates are today (2012), in 2013 (if Congress does not extend the Bush cuts), and what each Presidential candidate has officially proposed if elected in November.  

As you can see, the various tax scenarios as of January 1st 2013 are all over the board.  To compound an already complicated matter, in my opinion, we, the United States, have a lame-duck and partisan-divided Congress at the moment who is very likely to do nothing between now and the Presidential election based on their own self-interests.   

If I'm right about Congress sitting on their hands between now and November 6th, that only gives the Legislative Branch 29 business days to do something between the day after the election is held (Wednesday November 7th) and when they recess for the year on Friday December 14th.  I don't know about you but I do not have much faith in this particular Congress to do much these days, let alone in 29 days!  See August 2011 when the same Congress took the country to the brink by threatening to not extend our nations debt limit. 

Regardless of your political ideology, whoever is elected President on November 6th will have their work cut out for them to avoid watching us go over the proverbial fiscal cliff.  

Camelback Wealth's Six (6) Month Strategy

With respect to stocks, through our Rebalance process that we just completed, we remain defensive and will stay underweighted in the asset class - at least for the time being.  That doesn't mean we won't be invested in stocks, but simply not as heavily invested in them as we would under normal conditions.   

As for bonds, with Chairman Ben Bernanke and the Federal Reserve on record that they do not plan to increase interest rates until, at the earliest, 2014 we feel confident at this juncture of staying short to intermediate term on our bond holdings and reap the benefits of our existing income streams.  We also will be increasing our exposure to our private debt fund that is paying North of 7% per year. 

Lastly, in the alternative investment arena we have increased our exposure for the next 6 months in this category to take advantage of the significant volatility in stocks as a direct result of the uncertainty going on in Europe - which we expect to continue through 2012, at least!

Additional Reading 

If you are interested in reading more about the subject of the tax implications on January 1st, 2013, I've included a link to an excellent article below from the Wall Street Journal.  The article discusses the potential harming effect to stocks if the Bush tax cuts were to sunset on December 31, 2012.

Wall Street Journal Article by Donald L. Luskin