Stocks down again yesterday but interestingly bond yields up a tad, dollar down a tad, oil and metals up, and even long BMA ratios holding steady, etc.

The cliff isn’t nearly as large and threatening as the debt ceiling cliff would have been in 2011 if that thing hadn’t been extended, and we’d gone cold turkey into an immediate and forced balanced budget. But that event is the stock market’s ‘recent memory’ of stock market reaction functions.

And this time GDP is being supported by a private sector credit expansion/housing expansion, with private debt service ratios substantially lower due to cumulative federal deficits adding to nominal ‘savings’. And the federal deficit remains well above 5% of GDP, which historically has been more than enough to reverse a recession.

And then there’s the election factor. Post election I’m hearing (anecdotally) distraught Romney supporters thoroughly convinced the President is a ‘socialist’ bent on destroying capitalism, taxing the rich ‘job creators’ and giving it to what Romney called ‘the 47%’ dependent class, etc. etc. etc. Merits of this ‘belief’ aside, it looks to me it’s driving portfolios to shift out of equities. However, if not supported by an actual decline in earnings, which is how I see it, it’s all a case of ‘pushing on a spring’.

Yes, the euro zone is a problem, with Q3 GDP just reported at -.1%. But that’s an ‘improvement’ from q2’s -.2% as larger deficits are acting counter cyclically to cushion the austerity driven decline. And Rehn was just quoted on Spain favoring not adding to austerity measures, perhaps indicating a move to ‘let it be’ for a while, which will allow GDP to stabilize at modestly positive levels.

And China is no longer going backwards, so that negative has been reversed as well.

Back to the cliff, in fact letting tax rates go up for high income earners should have little effect on GDP, as the marginally propensity to spend for that segment is reasonably low. (of course that means there’s no point in taxing that income in the first place, but that’s another story). Nor does it mean investment or employment will suffer since investment is driven by sales prospects. And with higher tax rates, and business expense tax deductible, the after tax cost of investment goes down with higher tax rates. For example, in the 70’s, when my tax rate was around 70%, I clearly recall making very high risk investments figuring it was better than giving 70% to the govt. Point is, taxing income and savings that isn’t going to be spent is about social engineering, and not ‘funding the deficit’ or altering aggregate demand, and is intellectually honestly framed as such. So point here is, I score the effect of raising the highest tax rates at 0 regarding aggregate demand.

This all supports my take that the stock market has over discounted the cliff, partly for ideological reasons, partly due to the recent memory of what stocks did during the debt ceiling debacle, and partly from fear of what’s going on in the rest of the world.

So as we get through it all with modest top line and earnings growth continuing, I’m looking for valuations to quickly return to at least where they were before the election.

37 Responses

  1. The problem Warren, is if the Democrats trade higher tax rates for spending cuts. Obama is now demanding bigger tax increase, and the Republicans will now demand bigger spending cuts. Like a snake eating itself.

    1. @Mcwop, Yes, that does seem like a problem. The spending cuts will hurt far more than the top tax rates but the Republicans can hold taxes on the middle class hostage. That could result in lower consumer spending (sales). Then add spending cuts on top and the problem gets worse. Perhaps a deal will be cut to avert it all. But I am somewhat pessimistic on that score given the ideological nature of the Republicans.

      We shouldn’t forget the expiring break on payroll taxes and unemployment insurance. So there are some real potential problems out there, likely more than any tax “justice” for the liberal base. Advantage Republicans, if they play it right.

    1. @Neil Wilson,

      ““investment is driven by sales prospects”

      I’d like to brand that on the forehead of anybody who says we need to cut interest rates to ‘boost investment’.”

      And yet this is exactly how ‘reforms’ are being ‘scored’ by the mainstream. Across the board, there’s an assumption that beyond the short term, smaller deficits will support higher growth. It’s maddening.

  2. Isn’t the debt ceiling still in play here?

    For example, Sen Corker said something to the effect, ‘Don’t worry about the fiscal cliff, we won’t let that happen. What we should worry about is USG solvency.’ Which I take to mean another debt ceiling impasse in one of the next three quarters or so?

  3. Related:

    ECB chief Draghi waxes on the “ideal fiscal consolidation,” and ECB Executive Board member Joerg Asmussen says “all euro zone countries…must work harder if they want to keep up their living standards.”

    First question–has Asmussen entirely forgotten his Econ 101? Harder work for same material status = lower living standards, if I’m not mistaken.

    Second question follows from that–for whom is Draghi’s preferred form of fiscal consolidation “ideal”?

  4. of course that means there’s no point in taxing that income in the first place, but that’s another story

    There’s social engineering reasons, no? Also the existence of a tax allows exemptions to functions as incentives to avoid paying it — think charitable deduction or research credit.

  5. Warren,

    Questions of raising the current top-marginal rate aside, is there a case to be made that progressive taxes serve the function of regulating demand better than flat taxes or other fixed forms of tax payments?

    To me, it seems that a progressive tax code gives policymakers a greater time-lag to make adjustments due to an overheating economy.

    Like an auto-cooling mechanism that slows inflationary aggregate spending.

    Point is to apply taxes in the right fiscal spending context to achieve full employment, price stability, and new added production that raises our standard of living.

    And with all the savings demands…..we can have progressive taxes that collect that much less in taxes….

    Basically I’m trying to give Democrats something to work with here.

    The savings of higher earners offsets other agents dis-savings. Reducing the government deficit by raising marginal taxes and influencing a reduction in savings by wealthy income earners(reducing net-private sector nfa), also reduces the remaining capacity for the sustainable dis-savings of other private sector agents, which further reduces the capacity for remaining private sector gross saving in aggregate, intensifying recessionary pressures that challenge the government’s targeted (reduced) balance.

      1. @WARREN MOSLER,

        Progressive taxes provide marginal auto-cool settings for the thermostat!

        And the quickest way to make the tax code more progressive is the FICA payroll tax cut.


      2. how about a progressive real estate tax?

        the real savings on compliance costs gained by eliminating income and other transactions taxes
        seems to me to far exceed any possible ‘advantages?’

      3. @Charles Hayden,

        I agree. I’ve read SCE over 100 times. Gospel.

        I just think that progressive taxes can serve the purposes of taxes better than flat or fixed taxes….in the right spending context.

        So they don’t have to be necessarily looked at as tacking on a “social engineering” agenda to the function of taxes.

        The “social engineering” agenda is tacked on to the purpose of progressive tax policies.

        High marginal tax rates following the GD & WWII were part Athenian response to the 20s and demand management policy response to the desire for price stability w/ a new ‘massively’ sized government in an era of fixed exchange.

  6. There’s probably some tax-related selling in equities and spread product too as capital gains rates are set to rise (or are at least presumed to after Obama win) meaningfully for the first time since the tax reform act of 1986. I recall that equities suffered several bouts of selling in 1986 prior to the rise in rates from 20% to 28%. They then launched again in January 1987 (until October crash later that year) as monies were reinvested.

      1. @WARREN MOSLER,

        “For example, in the 70′s, when my tax rate was around 70%, I clearly recall making very high risk investments figuring it was better than giving 70% to the govt.”

        Do you see a parallel with the following comment about Ronald Reagan?

        “When the top marginal rate was 90 percent, actor Ronald Reagan worked just half the year. As soon as he made enough money such that every additional dollar was taxed at 90 percent, he stopped working and went off to ride horses. Reagan later said that woke him up to the damage that high taxes impose.”

      2. @Ed Rombach,

        So, Reagan was up to hoarding his earned income rather than channeling it to risky investments, which was an option he had? I am not an investor, so a question about income taxes: can you shield your income from taxes by investing it (in a given year)? I know, there are tax-deferred retirement savings and such, but they are all capped, aren’t they?

        Another thing, if someone is so well-to-do to be able to work half the year and then go off to ride horses (for whatever reason, including discouragement by taxes), why should that be a cause of concern for the society at large? Have producers who mattered, e.g., farmers, ranchers, teachers, doctors, truck drivers, …, ever be in such a position throughout history?

    1. @William Naphin,

      I agree. This is probably one of the reasons for the stock market decline. The cap gains rate is going from 15% to 23.8%, so I think it actually makes sense to sell in 2012, take the tax hit, and buy something new. The cost-benefit calculation is similar to the one you would do for converting an IRA to a Roth IRA.

      Also, the dividend tax rate (in the highest bracket) is going from 15% to 43.4%. That significantly changes the fair value of stocks to taxable investors, although it is under the company’s control to avoid this by buying back stock instead.

      1. @ESM,

        Yeah I know this is a popular meme but it doesnt make much sense to me really. If everyone sells now,and drives down the price, they will get less return. In addition when they rebuy next year at lower prices the gains they receive when ever they sell will be greater, making their tax bill greater. Playing this tax evasion game, it seems to me can be quite counter productive.It might work for the first to act but thats it. Once it becomes a popular play the affect is lost it seems to me.

        BTW ESM have you ever gone and checked out the MR site? Ive never seen you commenting there.

      2. @Greg,

        Well, my view is that taxes are extremely important when it comes to investing, and that most people ignore tax effects to their detriment. I find that people tend to sell their winning stocks to “lock in” their gains, but hold their losing stocks to try to get back to even. I do the opposite because the longer you can hold off paying tax, the better (this has definitely been Warren Buffett’s strategy). The goal is to maximize your after-tax return, not your pre-tax return.

        As for pre-tax returns, I think that that at worst you lose some transactions costs (i.e. commission and bid/ask spread). At best, you make money, since if anything there is positive serial correlation in individual stocks, so outperforming stocks tend to keep outperforming, and underperforming stocks tend to keep underperforming. This is a very slight, but real effect.

        I never quite understood why tax loss selling should affect the market as a whole, since most people who sell a stock to realize a loss just turn around and buy a new one. It should be a wash, except for the slight serial correlation referred to above. However, the so-called October effect is real (i.e. stock market underperformance in October), and that effect has been traced to mutual fund selling to realize tax losses for the year (their tax year generally ends Oct 31).

        I know about the MR site, but I rarely go there and have never commented. I know it’s a very good site, as is Steve Landsburg’s blog. There are others as well. I really only have time to follow one, and I’ve chosen Warren’s for better or worse. Besides the generally high level of discussion, one advantage for me here is that Warren attracts a lot of left-wingers, and I get a chance to engage them without the usual flame war nonsense or having my posts ignored or deleted. Warren’s blog might be unique in that sense. Of course, the disadvantages are that the commenting system is unwieldy, and the search function here doesn’t work at all.

  7. “intellectually honestly framed as such”

    By you, Warren, but the problem is that honest people have been framed by others.

    I appreciate that you do keep mentioning the caveats.

    We SHOULD be able to muddle through & even improve from here, IF bad policy doesn’t arbitrarily keep making things worse – here, or in Europe, or in China. That’s 3 ways to falter right off the bat. Meanwhile, in a domestic policy fight between Deficit Hawks and Deficit Doves, what’s the expected outcome? Seem’s like a low probability that they accidentally knock each other out and somehow fall upwards.

    It would take outside intervention, from what were discredited camps in both parties. That seems to be our hope. So far, Americans have always woken up just in time. Gotta hope it’ll happen again. You’ve certainly done your part in telling people what we could do. The fact that Kelton was actually invited to NAF, and the video distributed on C-SPAN, is actually amazingly encouraging. It’s surprising.

    Apparently you never know with Americans. We may do the right thing only after trying all the other things, but at least in the past we haven’t tried the wrong things too long or too hard before switching. That seems to be the forte of older, more established cultures (that, thankfully seem to be keeping up the habit of disappearing at just-adequate rates).

    Personally, I still fear that policy incompetence is the driving factor. We may have to fail harder before adequate amounts of people decide it’s time for a change in policy direction. What if we’re reverting to the European norm?

  8. Would it be possible to give a figure on how much deficit spending is needed at this point to get us back to full employment/capacity and solid growth? We’ve had consecutive years of trillion dollar deficits, yes, but how much more is needed in the short term (just 2013 budget for instance) do you think?

  9. “Back to the cliff, in fact letting tax rates go up for high income earners should have little effect on GDP”


    Reduce C modestly, reduce I, and reduce G will have little effect on GDP?

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