Do Higher Taxes = Higher Tax Revenues?

Tax collections have remained steady at about 18-20% of GDP since 1950. The government could certainly raise the top marginal rate back to the 70% rate of the 1970's, but they won't be likely to collect any more revenue. The proportional relationship between tax revenue and GDP has persisted with top marginal rates as high as 91% and as low as 29%. According to the data, the only way to increase tax revenue is to increase GDP. For a more detailed account of "Hauser's Law," follow this link:

http://www.theneweditor.com/index.php?/archives/8036-You-Cant-Soak-the-Rich.html

People off all stripes practice tax avoidance (both legal and illegal) as taxes get higher. And it's not just the domain of the uber-rich hiring tax lawyers to find obscure and complicated loopholes. If you are a cigarette smoker in New York, you know that the $3 per pack tax has made it more profitable for thieves to hijack a cigarette truck than an armored car. The black market is thriving as are cigarette sales in neighboring states. Why? Because nobody, rich or poor, wants to pay a tax rate that's confiscatory. It removes the incentive to work, produce and invest.

More evidence that markets are self-correcting...

Drivers in Boston are trading in their SUV's for fuel efficient sedans....and it didn't take a single piece of government legislation. Consumers will mandate fuel efficiency standards much more efficiently than Uncle Sam. Read the whole thing.

http://www.boston.com/news/local/massachusetts/articles/2008/05/06/frustrated_owners_try_to_unload_their_guzzlers/

Energy Policy

So here's what passes for energy policy from the remaining three presidential hopefuls:

Clinton/McCain: A "gas tax holiday" which would eliminate the 18.4 cent federal gas tax during the summer driving season. Think about the math for a minute. The average driver logs about 1,100 miles per month. Assuming average MPG of 19, that's 174 gallons of gasoline. Estimated tax savings for your average driver: $31.96 or 36 cents per day. McCain says this will give low-income Americans "a little break" over the summer. Little is a huge overstatement. If this policy proposal is influencing your vote, then your vote can be had for a daily 10-piece pack of juicy fruit.

Obama/Clinton: A windfall profits tax. Obama rightly calls the gas tax holiday what it is - pandering for votes. His idea (and Clinton's with a few differing details) is to take an additional 10% of oil company profits and redistribute them as the government sees fit. This is a very slippery slope. Microsoft made about $14 billion dollars last year. Is that a "windfall?" How about banks? Citigroup had over $62 billion in net income from 2004 to 2006. Why not take more of those profits, redistribute them, and make mortgages more affordable for everyone? In the long-term, any policy of this nature is self-defeating. If each dollar of marginal income is taxed at a higher rate, investment will inevitably decline. As investment declines, production declines and prices rise.

Politicians would be better served to start telling their constituents the things they don't want to hear. The era of cheap oil is over. We need to be thinking about ways to decrease demand and increase supply. Higher gas and oil prices are actually quite necessary to achieving this goal. With higher prices, new technologies become economically feasible. Consumers demand automobiles which provide the best combination of fuel economy, size and power. It would be nice if the government would enact policies that provide long-term leadership instead of myopic gimmicks.

Entitlement Programs

If current trends persist, Medicare and Social Security will consume a whopping 76% of all federal income tax revenue by 2050. This is before a penny is spent on national defense or Medicaid (health care for the poor). Higher taxes are almost inevitable. How much higher is the million (or perhaps multi-billion) dollar question.

Congress isn't making the tough choices necessary to attack this problem, because to do so would almost certainly lead to lost elections. Americans are in favor of spending cuts in the abstract, but start talking about exactly what to cut, and it becomes a dicier proposition. It's almost impossible to imagine a politician running on a platform of raising taxes and reducing entitlement program benefits, but this is exactly what has to be done sooner or later. In the meantime, most pols are hoping beyond hope that we can somehow grow our way out of the problem. Good luck with that.

For folks at least 10 years from retirement, I would suggest a Roth IRA if you are eligible (after-tax contributions are after tax but withdrawals are tax-free). If you make too much money, consider a Traditional IRA with an eye toward converting to a Roth in 2010 when the income limit for conversion is lifted.

The Dreaded "R" Word

The odds have grown that the economy will slip into a recession. At the beginning of last year, many economists put that chance at less than 1-in-3; now an increasing number says it has climbed to around 50-50. Goldman Sachs, the biggest investment bank on Wall Street even thinks a recession is inevitable this year. For its part, the Federal Reserve is not calling for a recession. It’s often repeated that economists have predicted 20 of the last 10 recessions. This is probably true to a certain extent given that many prominent economists have been calling for a recession every year since 2004.

Nobody has a crystal ball, but history provides at least some clues as to how the market might behave if we do see a recession.

Stocks and Recessions:

The 90-91 recession probably looks the most like today – a bad housing market accompanied by bad loans hurting banks and a pro-active Fed cutting rates even before the recession began. In the three recessions between 1980 and 1991, market performance was the ugliest prior to the recession when investors panicked about the effects of a downturn in earnings.

The 2001 recession was caused by a combination of high stock-price valuations and a huge decline in corporate earnings. Prior to the 2001 recession, the P/E ratio hit an all-time high of 46 times earnings. This is encouraging given that the trailing P/E is currently about 16. At current price levels, it would take an earnings decline of 65% to achieve a P/E of 46 again. Additionally, sharp declines in earnings always have been temporary, caused by recessions or other special circumstances, and earnings as well as stock prices have rebounded subsequently. The average return in the 6 months following each recession since 1969 is 11.7%. Professional economists can’t even predict the start of a recession accurately let alone it’s length and severity. The best course of action, as always, is to stick to a carefully considered asset allocation plan. Even a seasoned trader like James Cramer will tell you that the only free lunch in the stock market is a well-diversified portfolio.