Since the election, budget issues have been dominating recent stock market action. While nothing has fundamentally changed with regards to the budget, there is now a greater sense of urgency that action needs to be taken.
The reason for the sense of urgency is that as of January 1st the Bush tax cuts expire, and tax rates revert back to higher levels. Complicating matters is that the new Congress will not take place until after the first of the year, and typically during a “lame duck” session of Congress major legislation is not passed.
There are some who fear that if no compromise is reached and the tax rates revert back to higher levels, a recession will then ensue. I believe the likelihood of that occurring is remote. Most likely a short term extension of the old tax rates will take place giving the new Congress the opportunity to pass a change in tax and spending legislation next year.
The major unknown is what the new legislation might look like. The election essentially did not change anything other than the Democrats picking up a few seats in Congress. The House is still controlled by Republicans and Democrats possess the Senate and the Presidency.
One thing that will almost certainly occur is that higher income people will pay more in taxes, as Republicans have expressed a willingness to increase revenue. The unknown is whether this will be by higher tax rates, or by having fewer deductions. The Democrats are in favor of higher rates, while the Republicans favor less deductions.
One point to consider is that higher tax rates do not necessarily increase revenue. Throughout our history we have had many periods where tax rates for high income people were 50% or higher yet the rich did not pay more in taxes than they do now. If loopholes and tax deductions remain in place the rich will almost certainly take advantage of them.
One area that has received less attention is corporate taxes. The United States has one of the highest corporate tax rates in the world, but the revenue realized is relatively low because of many loopholes. The President has expressed a willingness to lower the corporate tax rate and close loopholes, which would be beneficial if it took place.
If President Obama has that line of reasoning on corporate taxes then possibly he could extend that logic to individual taxes. A compromise, where tax rates for the rich stay the same, but they have fewer deductions would likely be better for the economy, than if the rich were faced with higher tax rates.
Also in California with tax rates rising on the rich, if federal tax rates increased, some taxpayers could be faced with combined federal and state rates over 50%. Over time rates that high would likely have some impact on job creation and economic activity in the state.
We have had numerous changes to our tax code over time and our economy manages to survive. The stock market might remain somewhat jittery until there is a sense of what the new legislation might look like. However, with the recent selloff since the election, the stock market is quite attractively priced.
If someone’s percentage holding in stocks is less than normal this might be a good time to add to positions. Even with the likelihood of individual taxes increasing next year, the possibility of lower corporate tax rates would be a positive offset for the stock market.
