The State of the Union and the president’s budget are two pieces of information that reveal the president’s intentions regarding what he would like to accomplish. This does not mean that the proposals and initiatives outlined in them will come to pass. That depends on how much support the president will get from either his party or the opposition in Congress. But that is not the issue we want to deal with here. Our objective is to try to get a sense of where President Obama really wants to go. To do that we have to look beyond the rhetoric and focus on the substance of his proposals and suggestions. The reason this is important is that if the president is successful, his agenda will be implemented. If he is not successful, at least we know the direction that President Obama would like to take. That gives us a sense of, at least at the margin, the economic environment that the administration will create.
The performance of his State of the Union speech reaffirms what we already knew, that the president is a gifted speaker. The speech and subsequent documents also show that there has been a great deal of repackaging of the message, but in our opinion the substance has remained the same. All we see is some modest modifications in order to make them more palatable in light of current political realities, but substantively, nothing has changed. He is still calling for a repeal of the Bush tax rate cuts, now modified to those in the higher tax brackets, hence keeping his campaign pledge “of cutting taxes for the bottom 95% of taxpayers and raising them for the top 5%."
One modification here is that in returning the top brackets to the Clinton tax rates, President Obama will not disadvantage dividends over capital gains. That is a good thing. The president also reiterated his call to tax the foreign earnings of domestic corporations. Yet he failed to mention that those earnings are subject to foreign taxes and that when the earnings are repatriated they are subject to U.S. corporate taxes. The current tax treatment for foreign earnings is analogous to IRAs for individuals. The income allocated to the IRA is not taxed until it is withdrawn from the IRA. In the meantime it compounds tax-free.
The president still wants to redistribute income. He wants the rich to pay for his programs and he still believes in big government. Remember his response to Joe the Plumber that he wanted to spread the wealth around. His sincerity is not in question, what is in question is whether these policies will work as he expects. It is nice to spread wealth around. But will there be new wealth creation if you spread wealth around or will some people just wait for someone else to create wealth and then have it spread to them? We believe that the act of spreading the wealth around will alter the economy’s incentive structure and, as a result, will have unintended consequences. We believe the outlook is going to be different than the one the president contemplates in his budget document.
Our argument is simple, the president wants to regulate and micromanage the economy. He has stricken a populist view by denouncing insurance companies, banks, oil companies, investment managers and those making over $250,000. We believe these policies will have a negative impact on economic growth and stock market valuation. He is still pushing his agenda. If not, why would he say that
All that’s changed in the last two weeks is that our party has gone from having the largest Senate majority in a generation to the second largest majority in a generation.
He has also signaled his willingness to maneuver to get his agenda implemented. For example, there is talk of the House passing the Senate health care bill and then “fixing it” through a reconciliation bill. These are not rumors that reassure the electorate that President Obama has heard them and learnt his lesson.
Even if the president fails to pass his agenda, he will be able to implement a great deal of his agenda through executive orders and through other regulatory and administrative measures. One potential example is cap and trade. Will he try to implement it administratively? Other examples regarding his beliefs and objectives were given during his State of the Union speech. When he riled against the Supreme Court, he urged Congress to write legislation to overturn their decision. Another example was when he commented that the Senate voted down the deficit commission. Senator McCain had it right, when he said that we should have had a spending commission, but that is beside the point. The issue to us is that the president defiantly said that he was going to implement it by executive order. In both cases he was within his rights to act. All we want to point out here is that his actions are not those of a person who is trying to mend his ways. He is pursuing the same agenda that he has been pursuing for some time. True, these actions will be “temporary” and could be easily reversed by a new occupant of the White House, but that is a few years away. So in the mean time we will have to deal with what is likely to be the underlying trends for the economy based on the likely policy responses of the Obama administration.
The Era of Big Government
The president is very good at pointing out that he inherited the recession and that he had to spend to prevent the economy from going into a tailspin. This is a matter of debate. Maybe the economy has some automatic equilibrating forces and government intervention only delayed the adjustment. We will leave that for the historians to decide. What we are interested in discussing is the fact that Obama’s economic proposals will lead to what we may call a permanent increase in the size of government. Our case is simple, as the share of GDP federal spending is projected to increase to a postwar record of 25.4% this year. If everything goes as planned by the Obama administration, the size of the figure will decline to 23% by the middle of the decade. To put this in perspective, all we need to know is that the 40 year average of spending as a share of GDP stands at 20.7%. The conclusion here is simple, we are more than likely to see an expansion of the public sector over the next few years.
The Pressure to Raise Tax Rates
We take the president at his word:
It’s time to save what we can, spend what we must, and live within our means once again.
We will discuss whether we are spending what we must later on. For now, let's focus on the last part of the statement. To this end, the president has proposed implementing a PayGo provision. It is being sold under the guise of fiscal responsibility in that with PayGo in order to pay for additional spending, Congress will have to come up with the incremental revenues. Although not necessarily part of PayGo, we know that the scoring of these initiatives is basically a static one. Hence by definition a tax rate cut will be a revenue loser, and that requires additional taxes or a spending cut. Now if there are any dynamic effects of the sort that supply-siders argue about, this means that PayGo will introduce a systematic bias for higher spending. The reason for the bias is simple. If tax rates increases will create incentives for avoidance and, thus, reduce the tax base as a result the revenue collected by a tax rate increase will be smaller than the static estimates.
Similarly, the revenue collections after a tax rate cut will be larger than the static estimates. PayGo will systematically overestimate the revenue collections of tax rate increases and underestimate the revenue collections of tax rate reductions. Hence the static revenues estimates will tilt the balance in favor of a larger government and higher tax rates. Now add to this the persistence of the budget deficit as projected by the president’s budget and one can see that the budget is nothing more than a time bomb that will inevitably result in higher taxes. That is why we believe that a budget deficit committee will inevitably recommend tax rate increases to close the deficit gap. What we need is a spending commission. That is why we believe that even if the president is not successful in Congress, he still has the power to set the agenda.
How one frames a problem matters. A deficit problem means that one can close the gap by cutting spending and raising taxes or a combination of both. A spending problem means that spending must be cut. This, in turn, leads to another policy issue of what to cut. A revenue problem means that revenues must be increased. Here the policy issue is how to raise additional revenues. Given the projections regarding government spending, the PayGo provision and the static scoring of revenue measures there will be enormous pressure to raise tax rates on the “rich”. So we look for the economy’s marginal tax rates to increase.
The Politics of Special Interest Groups
Income redistribution and the static view of the world implicit in the administration’s proposals and policy initiatives also leads to a bias towards higher taxes and a larger government. Under the static view, a fixed pie leads to a zero sum gain. One group’s gain is another group’s loss.
One issue reinforcing the re-distributive aspects of the politics of special interest groups is the fact that we are now approaching a situation where the majority of taxpayers do not pay federal income tax. The top 1% pay 40.4% of income tax revenues, while the top 5% pay 60.6% of income tax revenues. It is easy to see that the math does not work in favor of high income taxpayers. Under a static view of the world the politics of special interest groups are tilted in favor of income redistribution schemes, higher tax rates and bigger government. So a politician that is able to marshal the forces of lower income people may be able to get elected on an income redistribution, share the wealth platform aimed at taxing the top 5% and redistributing it to the bottom 95% of taxpayers.
The politics of special interest groups has other effects on the economy. Attempts to collect more from the “rich” will shrink the tax base and at some point in time retard the economic recovery. The rich tax base is not large enough to raise all the revenues needed by the Obama spending projections. Tax rate cuts will expand the tax base. So the issue is whether the dynamic effects are sufficiently large enough to overcome static revenue losses. But that is contrary to the redistributionist agenda of this administration. The way to combat the zero sum static redistribution scheme is to argue that dynamic effects will be large enough that in due course tax rate increases will lead to a smaller tax base and slower growth. They idea here is to convince enough voters of the dynamic view and argue that, in the long run, they will be better off. Ronald Reagan did it and Scott Brown did it. So it is possible to argue the dynamic case.
Another factor pushing the politics of special interest groups is the public employees unions, which are largely sheltered from the vagaries of the markets. Public employees are seldom fired, unless they are really incompetent. Benefits are fairly secure, even when a city or public entity declares bankruptcy. One can see why public employee unions are not only in favor of higher government and higher taxes to finance the government but will also actively pursue policies that lead to a larger government and consequently higher tax rates. There are several ways to deal with this problem. One is to limit the size of government and/or its expansion. Gram-Rudman-Hollings is one piece of legislation that effectively limits the growth of the public sector. Other policy actions require toughness on the part of the executive branch. President Reagan’s firing of air traffic controllers is one such example that arrested the growth of unions in the public sector. Short of that, we will see a continued growth in public sector unions and a systematic bias towards more government and higher tax rates.
The Incentive Structure
In a static framework, as we already explained, the politics of special interest groups lead to a larger government as well as to a greater degree of income redistribution. Given the fact that the majority of taxpayers do not pay federal income tax, it is not surprising that they would tend to go along with tax increase proposals aimed at the rich especially as advocates of these proposals tend to exempt lower income people from these taxes. However, taxes are only the financing side. In the context of a democracy, one person, one vote. It makes sense in terms of the politics of special interest groups to single out a small group to pay for actions and spread the benefits or at least spare the costs to the majority of the people.
The benefit distribution side of special interest groups leads to a slightly different dynamic. Whether it is coming from the government that wants to regulate behavior or the groups themselves, the narrower the base or the smaller the group benefiting the bigger the bang for the buck of a government redistribution scheme. Also a narrow base means lower costs and more resources available for other special interest groups. The conclusion of our discussion being that when it comes to distributing benefits and/or goods and services, the politics of special interest groups lead to targeted incentives aimed at benefiting a narrow group or class of people.
The problem with the narrowness of the measure is that they tend to increase the level of distortions vis a vis those who do not qualify. When all is said and done, we conclude that populism and the politics of special interest groups will lead to regulatory and tax rate changes that will significantly affect the economy’s incentive structure. The increase in distortions will lead to a reduction in incentives to work, save, invest and produce, the end result being slower growth and an overall lower level of income.
Government Services, Income Redistribution and Aggregate Demand
One of the justifications for the increase in the public sector was the famous stimulus program. It serves two purposes in one. The first purpose is to increase aggregate demand and, thus, reactivate the economy. The second purpose was to redistribute income, even if there was no net stimulus. It was to “spread the wealth” as then candidate Obama put it during his presidential campaign.
Under some general conditions, the size of the government does not matter and expanding the government will not lead to an increase in aggregate demand. Let’s review these conditions. If the public sector is as efficient as the private sector in the provision of public services and the latter are substitutes of the private sectors services, the cost of producing the services should not matter a great deal. Take the case of school lunches or public education. If they are as good as the private sector provided services, then the government provision of these services will lead to a one for one offset. That is the private sector will now buy less of the services provided by the government.
A related issue is how the government will pay for these services. Again if there are no collection costs, the amount collected would be exactly what people were previously spending and, thus, there is no net income effect. The public sector would simply replace the private sector in the provision of the services.
Looking at the assumptions made in the previous paragraph we can see that under these conditions, increases in public spending in the provision of public services that are substitutes of private services will not lead to a big impact on aggregate demand.
In order to have an effect on the economy, we need to relax the assumptions made. Let’s begin by assuming that the government wants to redistribute income. In doing so it will collect more resources from some groups and give these resources to other groups. The people whose income has gone down will reduce their total aggregate demand while those that receive the extra benefits will increase their aggregate demand. Yet if they have similar marginal propensities to consume, one group’s gain will cancel the other group’s losses. There will be no net effect on aggregate demand. So in order for a redistribution scheme to have any impact on aggregate demand, there would have to be differences in the marginal propensity to consume of the different groups. Milton Friedman’s research on the consumption function and permanent income hypothesis tend to discredit this view of the world.
The process of elimination leads us to consider the efficiency of the government in producing goods and services. If the government is less efficient, measured aggregate demand will increase but this is not desirable because the economy’s well-being will decline. To see this consider a natural disaster destroying wealth, like a tsunami or an earthquake. The economies will rebuild and during the rebuilding phase economic activity will pick up, but clearly the people of the region will be worse off. The one case where an increase in government spending can lead to an increase in aggregate demand and make people better off is in the case of a “public good”. National defense is the usual case made in textbooks. The Tennessee Valley Authority (TVA) is another example of a public good that may have led to an increase in aggregate demand. However, looking at the Obama stimulus package, very little of the funds have been spent on potential public goods.
Even when government spending does not lead to an increase in aggregate demand, some people may still choose to redistribute income if they believe that making income distribution more egalitarian is a good thing. We say maybe, because there is a little matter of the financing of the spending. Higher tax rates create disincentives and, thus, tend to reduce output and the rate of economic growth. Some possible examples will illustrate our point. In scenario 1, the income of people at the bottom triples and the income of top income earners increases by a smaller amount. Here everyone is clearly better off. In scenario 2, the opposite situation occurs, the income of the poor falls by less than the rich. Here the income distribution is more even, yet everyone is worse off. But this is not what we are talking about, the president has clearly argued that it may be desirable to make one group better off at the expense of another group.
To decide whether society is better off or not, one has to make some sort of value judgment about the trade off of well-being among the different classes or interest groups. For the benefiting groups, the calculus is different. If they don’t care about the other group, all that matters is that they are better off. Yet we argue that redistribution policies will have unintended consequences. They lead to higher marginal tax rates and more regulation than in the long run, slows the economy’s growth rate.
Likely Trends
If President Obama is successful in implementing his agenda we know that the size of government, marginal tax rates and government regulation will increase over the next few years. However, we contend that even if he is not successful, he can still push his agenda at the margin, and implement many of his policies through executive orders and/or the actions of federal government agencies. Our view is that over the next couple of years the economic environment will be dominated by Obamanomics. However, the strength of the influence of the president’s views will depend a great deal on his legislative success. But there is no question in our minds that Obama will dominate the economic environment.
Investors then have to worry about the economic trends that an Obamanomics dominated environment will engender and from there develop appropriate investment implications. While there could be cyclical swings away to what we believe is going to be the underlying trend, in this section we concentrate on what we consider are likely to be the underlying trends during President Obama’s term.
In the context of the classical model, higher tax rates, more regulation and a greater degree of government intrusion in the economy will likely produce a slower growth rate than would otherwise be expected. Although we believe that the expiring Bush tax rate cuts will lead to a stronger 2010, it is only a shifting of income to the present. We look for a slower growth rate in 2011 and quite possibly beyond. We expect the U.S. to lose ground to the rest of the world, for global investors an underweight of U.S. equities may be warranted in particular if the president is able to get his proposal to tax the foreign earnings of U.S. corporations passed. We also expect the dollar to weaken in such an environment.
Although monetary policy is not directly under the Obama administration, we look for the inflation rate to increase some time after 2010. An environment of higher taxes, rising regulation and rising inflation will, according to our research, favor the smaller capitalization stocks. Unfortunately, the lack of credit will affect smaller cap stocks negatively. Putting this together with the tax on foreign earnings, our view is that the mid-cap stocks are sufficiently nimble to circumvent much of the government regulation, to have access to the credit markets and to have minimal foreign earnings. So we look for mid-cap stocks to outperform.
The populist policies will have a significant sectoral impact on the economy. Astute investors who pay attention to political shifts may be able to implement a successful industry and/or sector strategy. For example, the president has riled against the financial industry, in particular the banks that took TARP money. We have seen proposals on how to tax profits, somehow restrict bonuses, regulate them to reduce the systemic risk, and now there is even talk about raising their reserve requirements. Broker dealers could find their leverage affected, and private equity may be taxed as ordinary income. Clearly these are not bullish measures and they will have a negative impact on the financial sector. Perhaps one may have to reconsider their financial sector exposure. Also while cap and trade may not go through the president has proposed the elimination of some tax breaks in the energy sector. Add to this the fact that the Environmental Protection Agency (EPA) may be able to regulate them and we have the makings of expensive litigation that could last years and would have the same effect as a tax on the industry, the only difference being that the lawyers will collect a fee instead of the Treasury collecting a tax. Clearly, the EPA regulations will not affect all companies in the industry the same way. This means that while we may rethink the energy sector as a whole, there may still some reasonable investments within the sector.
The expansion of the public sector will lead to a crowding out of some of the private sector providers. So one has to pay attention to the sectors where the government is planning to compete with the private sector. If the competition is fair, the private sector has no worries. Unfortunately, the government has very deep pockets and it may under price and outlast the private sector provided services. At the very least it will take some market share. So beware of direct competitors and look for the suppliers to the public sectors.
While we do know that tax rates are likely to increase, if the president has his way he will preserve the equal treatment of capital gains and dividends in the tax rate. When both are being taxed at a lower rate than the individual income tax, we must remember that capital gains and dividends also have to pay a corporate income tax rate. The equal tax treatment suggests that there will be no advantage for value stocks over growth stocks due to a difference in dividend/capital gains tax rates. However, due to the double taxation of dividends and capital gains, debt will increase its relative advantage over both capital gains and dividends. So we expect that when credit stabilizes and the economy recovers, corporate bond financing will increase and so will corporate debt.
Finally, when all this is put together we will favor smaller cap companies that have access to credit and not much exposure to foreign earnings. One simple way to play this may be to buy the equal weighted S&P 500.
