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The Economy & The Mother Of All Tax Hikes

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
November 6, 2007

IN THIS ISSUE:

1.  The Economy Surprises On The Upside, Again

2.  The Bank Credit Analyst’s Latest Thinking

3.  The Fed Cuts Short-term Interest Rates Again

4.  Charlie Rangel’s “Mother Of All Tax Hikes”

5.  Rangel’s Idea, Or Hillary’s Trial Balloon?

Introduction

There has been a good deal of surprising news over the last week or so, both on the economic/investment front and on the political front.  The Commerce Department announced last Wednesday that Gross Domestic Product soared at an annual rate of 3.9% in the 3Q, well above pre-report expectations.  Consumers did not retreat from spending in the 3Q as many had expected.

The Fed lowered interest rates again last Wednesday, and once again lowered both the Fed funds rate and the discount rate, which came as a surprise.  In its policy statement, the Fed indicated that it does not expect to lower rates further anytime soon, but that remains to be seen.  The Fed hinted that there has been some improvement in the housing slump, but that is likely wishful thinking.

Last week, we also got the early details on Representative Charlie Rangel’s new “Mother of All Tax Reform” legislation that he is promoting.  If enacted, it would be the largest tax increase in US history and would (surprise, surprise) soak the rich, as well as many in the middle class.  I will summarize the highlights of Rangel’s tax hike legislation below.  The real question is whether Rangel came up with this tax hike plan on his own, or was he put up to it and if so, by whom?

The Economy Surprises On The Upside, Again

The US economy definitely surprised on the upside - once again - in the 3Q.  On Wednesday of last week, the Commerce Dept. reported that 3Q GDP rose a whopping 3.9% (annual rate), well above the consensus expectation for a number around 3.0%.  The 3.9% rate in the 3Q follows the prior surprise of 3.8% in the 2Q.  Frankly, I don't know what the gloom-and-doom crowd is going to say now; well, yes I do - they will keep warning of the end of the world no matter how good the economy is or how high stocks go.  Here is how economist Larry Kudlow described the news on the economy:

“If things are so bad, why are they so good?  With all the gloom coming out of Wall Street, the Democrats on the campaign trail and the mainstream media, a remarkable thing just happened: Real gross domestic product, the best summary report of the American economy, came in at a breathtaking 3.9 percent annual rate for the third quarter. In fact, following the 3.8 percent growth rate for the second quarter, the U.S. economy has posted its strongest quarterly growth in four years. The economy actually appears to be speeding up, following the relatively sluggish performance of the prior 18 months.

On top of this, the inflation rate is actually slowing down. The consumer spending deflator is reading 2.1 percent for the past year, compared to over 3 percent six quarters ago. The core inflation rate is down to 1.9 percent, below the Fed's 2 percent target.

Even employment is holding its own. According to Automatic Data Processing's private employment survey, which showed its strongest gain in four months, October looks like it will produce about 125,000 new jobs.

Meanwhile, rising exports of American goods and services are booming to such an extent that the deep housing recession is being cancelled out. And while many continue to predict a consumer collapse because of falling home prices and tighter credit, after-tax inflation-adjusted income is 4.1 percent ahead of last year, for a $344 billion gain…  Again: If things are so bad, why are they so good?”

According to the Commerce Department’s latest GDP report, real personal consumption expenditures increased 3.0% in the 3Q, compared with an increase of 1.4% in the 2Q.  Durable goods orders increased 4.4% in the 3Q, compared with an increase of 1.7 percent in the 2Q.  Nondurable goods orders increased 2.7%, in contrast to a decrease of 0.5% in the 2Q.  Services expenditures increased 2.9%, compared with an increase of 2.3% in the 2Q.  Real nonresidential fixed investment increased 7.9%.   Yet the largest increase in the 3Q was in the area of exports, which were up a whopping 16.2% for the quarter, compared to 7.5% in the 2Q.  US exports are on a tear this year, but we see little news on this in the media.  Real federal government consumption expenditures and gross investment increased 6.8% in the 3Q, compared with 6.0% in the 2Q.  National defense spending increased 9.7%, compared with an increase of 8.5% in the 2Q. 

While the economy did surprise on the upside again in the 3Q, there is little doubt that we are in a slowdown in the 4Q.  But even if the economy only grows 1.5-2.0% in the 4Q, it will have been a solid year of growth, and no recession.

The Bank Credit Analyst’s Latest Thinking

As you know, BCA has maintained all year that a recession was not the most likely scenario, and that the US economy could surprise on the upside.  As usual, they were right on.  However, in their latest report for November, the editors take a more cautious stand in their outlook:

“The U.S. economy will be sluggish in the next few quarters as the housing downturn grinds on, consumers retrench and businesses remain reluctant to invest. It would not take much in the way of additional negative shocks to tip the economy into recession… Even though recession should be avoided, the outlook is fraught with uncertainty.”

This language is definitely more cautionary than in previous months.  This is primarily because the editors believe the housing slump is far from over, and I agree.  While their most likely scenario is that we avoid a recession, they are quick to add in this latest report that it is possible that housing woes could lead to a further slump in consumer confidence, and therefore spending, which could tip the economy into a mild recession sometime next year.

BCA continues to be bullish on equities, although they believe market volatility is going to remain very high for the foreseeable future.  They also acknowledge that the US equity markets are overdue for a downward correction.  Still, they continue to recommend “above-average” holdings of equities.   

BCA continues to expect the Fed to lower short-term interest rates at least a couple more times in this cycle, despite the Fed’s rhetoric to the contrary (more on this below).  The editors believe the Fed can easily take the Fed funds rate down to 4% over the next several months.  BCA continues to believe that the trend in core inflation (minus food and energy) is down, and since the Fed seems to focus on core inflation, they should be comfortable in lowering rates more in the next few months.

As for bonds, BCA sees a continued broad trading range and recommends that investors maintain “below-average” holdings of bonds.  If they are correct, this is another reason to check out Hg Capital Advisors and theirLong/Short Government Bond Program.  They invest in Treasury bond index mutual funds and seek to deliver short-term capital gains.

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The Fed Cuts Short-term Interest Rates Again

As many in the financial industry expected, the Fed Open Market Committee reduced the Fed funds rate from 4.75% to 4.5% last Wednesday and once again lowered the discount rate from 5.25% to 5.0%.  The move to cut both short-term rates came as somewhat of a surprise in light of the very strong GDP number that came out earlier on the same day.

The fact that the FOMC lowered both rates once again – even with the booming GDP report - may be an indication that the Fed is taking the housing slump and the related credit crunch more seriously.  Here is the policy statement released by the Fed last Wednesday:

“Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance.  However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.  Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.  In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. 

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.  The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.”

It is the first sentence of the final paragraph of the statement above in which the Fed appears to be telegraphing a message to the financial markets that it does not expect to lower short-term rates again at the next FOMC meeting on December 11.  That remains to be seen, and another cut in December would not surprise me, especially if the housing news continues to worsen.

In another action in response to the ongoing credit crunch, the Fed pumped $41 billion of new reserves into the financial markets last Thursday, the largest cash infusion since September 2001, in order to help companies get through the credit crunch.  This would appear to be another indication that the Fed may not be as confident of the economy pulling through the sub-prime debacle as their latest policy statement seems to suggest.

Charlie Rangel’s “Mother Of All Tax Hikes”

Last week Rep. Charlie Rangel (D-Harlem, NY), chairman of the powerful House Ways & Means Committee, announced that he will soon be introducing new tax legislation which he called “The Mother of all Tax Reform.”  If enacted, this legislation would be the largest tax increase in US history!  If our readership demographics are remotely correct, the vast majority of you will see your income taxes increased significantly, while most of your deductions will be reduced or eliminated, if this new tax hike is enacted.

Titled the Tax Reduction and Reform Act of 2007, this new bill is actually going to be sold as: 1) a tax cut for the middle class and corporations; and 2) the elimination of the Alternative Minimum Tax (AMT).  Those things sound good, don’t they?  Who wouldn’t support a tax cut for the middle class? Certainly, getting rid of, or at least changing, the AMT is long overdue. 

The AMT, which was created in 1969, was intended to ensure that the super-rich were not able to dodge paying taxes, by enforcing a minimum level of taxation. Yet there was one big unintended consequence with the AMT.  The legislation didn’t include indexing for inflation, so over the years, the AMT has come to affect more and more Americans besides the wealthy.  For tax year 2007 alone, as many as 23 million Americans, including many in the middle class, will pay the AMT, unless Congress extends AMT relief provisions quickly.

If Charlie Rangel’s Mother of all Tax Hikes is enacted in its entirety, including the elimination of George W. Bush’s tax cuts, it will cost at least $3.5 trillion over 10 years. So where does Mr. Rangel propose to get the money to pay for this?  By taxing the rich, of course, but read this carefully: Rangel would raise taxes on any individuals making $150,000 and any married couples making a combined $200,000 a year!  Here is the analysis by Rep. Jim McCrery, the ranking Republican on the House Ways & Means Committee:

“At a bipartisan Ways and Means caucus last night, Chairman Rangel outlined his long-awaited “Mother of All Tax Hikes” legislation.  The basics of the package are simple: This is the largest individual income tax increase in history. 

The bill will add a 4% surtax on Americans earning more than $150,000 a year ($200,000 for couples).  That is on top of the scheduled expiration of the 2001 and 2003 [bush] tax cuts.  So, under Democrats’ plan, over the next few years, the individual income top tax rate in the United States will rise from 35% to 44%.  By way of comparison, the other 29 Organization for Economic Co-operation and Development countries – basically other developed nations - have an average top marginal tax rate of 35.7%.  In fact, only five OECD countries would have higher top marginal tax rates in 2011 than the United States if the Democrats’ bill is enacted.

This crushingly high tax rate will affect approximately 10 million taxpayers directly - including those who report business income, like small business owners and farmers - but the damage will ripple throughout our economy.  Because small businesses and family farms often pay their income taxes as individuals, this is a massive tax hike on the engine that drives job growth in this country. 

In addition, the surtax is on adjusted gross income, not taxable income.  This sounds like a technical issue, but it means that Rangel’s bill will erode the value of a series of tax deductions – including for mortgage interest, charitable giving, medical expenses, state and local taxes, and the standard deduction.  And, because the surtax kicks in at $150,000 for individuals and $200,000 for couples, the bill creates a monster of a marriage penalty.

Chairman Rangel will claim that these tax increases go to provide tax cuts to 90 million Americans, but he is selling pure snake-oil.  Many if not most of those taxpayers are getting a purely imaginary “tax cut.”  Some of them are the roughly 20 million people that Republicans shielded with the Alternative Minimum Tax patch.  Millions more are people who have benefited from the 2001 and 2003 tax cuts, and only get “tax cuts” if you assume that the 10% bracket, marriage penalty, and $1,000 per child tax credit will expire.  Others, like single people who will now be eligible for the Earned Income Tax Credit, are getting a tax refund from the government even though they don’t actually pay income taxes. 

It will take time to analyze this bill and sort through the data, but we know from the start that the 90 million figure is pure hokum.  In fact, before you know it more taxpayers may wind up paying higher taxes – and fewer paying less  - under Rangel’s plan than they did last year.

Which brings us to the larger fallacy of the Democrats’ “paygo” system.  There is no need to “pay for” protecting taxpayers from a massive AMT tax hike.  The government never meant for the AMT to affect middle-class Americans, and we have a responsibility to make sure it doesn’t.  By arguing that preventing this tax increase requires us to raise taxes elsewhere, Democrats are trying to lock Congress into a system where we are guaranteed to raise taxes by $3.5 trillion over ten years.

That’s right. $3.5 trillion. The baseline that the Democrats are using for “paygo” includes revenue from an “un-patched” AMT and from the tax increases that occur when the 2001 and 2003 tax laws expire after 2010.  Together they total $3.5 trillion over ten years.  If we play by the Democrats “paygo” rules, that is the size of the tax increase we are imposing on the American people.  That will hurt our nation’s competitiveness and cost us American jobs.  The Rangel bill is the first step down a road none of us want to follow, and I urge you to oppose it strongly.”

Rep. Rangel also proposes changing the tax rules for hedge fund managers and other money managers who take most or all of their income as capital gains, which currently are taxed at 15%.  Rangel wants them to take all their fees as ordinary income which is currently taxed at 35% for most of us.  As this is written, however, there is talk that Rangel has put this change on hold for now.

Tax “The Rich” – They Don’t Pay Enough

For as long as I have followed politics, the liberal mantra has always been “raise taxes on the wealthy” because, presumably, they don’t pay their fair share of taxes.  That is hogwash!   Just over a month ago, the Internal Revenue Service released income tax data for 2005.  The good folks at Tax Foundation have been tracking US income and taxation since 1932.  Here are some excerpts from their latest study on the 2005 tax data from the IRS:

“Do America’s wealthy pay their fair share of taxes? Most politicians say they don’t. But a new Tax Foundation study of IRS tax returns shows the highest-earning Americans pay an overwhelmingly large share of the nation’s income tax burden. According to the study, America’s richest 25 percent of taxpayers paid about 86 percent of all federal income taxes in 2005, despite earning only 67 percent of the nation’s income.

The highest-earning 1 percent alone— those earning more than $364,657—paid a staggering 39.4 percent of all federal income taxes, despite earning just 21 percent of the nation’s income. That means the top 1 percent of tax returns paid about the same amount of federal income tax as the bottom 95 percent of tax returns combined.

‘These new data overturn the widespread misconception that high-earners in America don’t pay federal income taxes,’ said Tax Foundation President Scott A. Hodge. ‘The federal tax code today is heavily skewed toward imposing very high tax burdens on high earners’…  Despite tax cuts in 2001 and 2003, federal income tax burdens are on the rise again. The study also shows the federal income tax code remains highly progressive, despite the often-repeated claim that the 2001 and 2003 tax cuts reduced tax progressivity.

‘There is a common misperception that America’s wealthy don’t pay much federal income taxes. This new study completely overturns that myth,’ said Hodge.”  To read the full study, go to www.taxfoundation.org.

So according to the latest IRS data, the top 1% of income tax filers – those who make $365,000 or more - pay 39.4% of all taxes paid.  The top 5% of income tax filers pay 59.5% of all taxes paid.  The top 25% pay 86%. Compare that to the bottom 50% of filers that pay only 3.1% of all income taxes paid for 2005.  The truth is, the percentage of taxes paid by the bottom 50% has been declining for decades; in 1980, for example, the bottom 50% paid 7.05% of all income taxes paid.  

By the way, don’t expect Rep. Rangel to quote these IRS statistics noted above as he lobbies for his Mother of all Tax Hikes!  And by the way, if you make over $150,000 as an individual or $200,000 as a couple, you are now defined as “wealthy” by Charlie Rangel!! 

How Rangel’s Tax Hike Hurts Small Business

We know what a huge tax increase on the wealthy (in this case $150,000 or $200,000 incomes and up) does to tax receipts over time.  But let’s focus specifically on how Rangel’s Mother of all Tax Hikes is a likely disaster for small businesses – especially small and closely-held exporting firms.

Small businesses are the engine of job creation in the economy.  According to the Department of Commerce, small firms employed almost 51% of the nation’s non-farm private labor force in 2004.  These 5.9 million small businesses employed 58.6 million people.  The numbers are much higher if we include the nation’s farmers and ranchers.  Small businesses make up a huge percentage of our nation’s exporters, and these private exporters produced 28.6% of the known export value in 2004, according to the Small Business Administration.  Obviously, these numbers are much larger today.

The Rangel tax reform bill takes direct aim at America’s job-creators.  It would raise the maximum marginal tax rate on all small business income – wages, distributions, capital gains and dividends – from 35% to 39% through the creation of a new “surtax” applied to incomes above $150,000.  And read this carefully: this surtax is applied to Adjusted Gross Income, not Taxable Income, so it comes before deductions.  That means it is really at least a 5-6% surtax on taxable income, because it reduces the value of your deductions for home mortgage interest, charitable donations, medical expenses, and other itemized deductions.

In addition to the tax rate increase, the bill also eliminates several tax provisions small businesses rely on in order to remain competitive.  It repeals the hard-won domestic producer tax deduction that was enacted just three years ago to help encourage manufacturing and domestic production here in the US.  Small and closely-held US exporters take a hit too.  The Rangel bill would repeal the last export tax benefit in the tax code.  This provision, known as the IC-DISC, was implemented to help small exporters compete in international markets.

According to the accounting firm RSM-McGladrey, nearly 40% of mid-sized manufacturers said they utilize the IC-DISC to make their exporting business more competitive.  The Rangel tax reform proposal would eliminate this export tool and raise the tax on income from these exports from 15 to 39%!  Repealing a pro-export tax benefit and raising tax rates on top of it will stifle export growth, which will ultimately mean reduced market share and fewer jobs in this very competitive global market economy, especially given that many other countries allow their companies to exempt export income from taxation altogether.

Rangel’s Mother of all Tax Hikes moves our tax code in the wrong direction, and it sends exactly the wrong signal to those firms who have made a decision to invest and create jobs in this country.  And as noted above, the Rangel tax plan would ensure the elimination of the Bush tax cuts, which means that small companies - S-Corporations, sole proprietorships and others that file as individuals - will face a top marginal rate of 44% starting in 2011, if Rangel gets his way.

Conclusions

Many Americans buy into the liberal mantra of “tax the rich.”  Likewise, many would agree with the notion that “the rich don’t pay their fair share of taxes.”  But as we’ve seen above, the wealthiest 1% of tax filers pay 39.4% of all income taxes, the top 5% pay 59.5% of all taxes paid, and the top 25% pay 86%.  Yet Rep. Rangel wants to raise their taxes with a 4% surcharge on “Adjusted Gross Income,” not Taxable Income, which effectively means the surcharge is 5-6%.

I think that many Americans agree with the “tax the rich” mantra because they believe that such tax hikes will never affect them personally.  However, if Rangel’s Mother of all Tax Hikes sees the light of day, it will affect every individual making $150,000 and couples making $200,000.  Many of these people do not consider themselves to be “rich,” especially those with families to support, or those who have only recently reached those income levels.  Many people who make $150,000-$200,000 consider themselves to be in the middle class.

And therein lies the main problem with the liberals and their agendas, especially with regard to taxes.  They start by targeting the wealthiest Americans, but over time their policies affect the middle class as well.  If Rangel is successful in setting the bar at $150,000-$200,000 now, you can expect the net to be expanded to even lower income levels in the future, especially if Hillary or Obama win next year.

Unlike the AMT which has become onerous due to Congressional oversight in not indexing it to inflation, Rangel’s Mother of all Tax Hikes is a calculated assault on not only the rich, but also millions of Americans who consider themselves to be in the middle class.

Earlier on, I said that I would discuss whether this tax cut idea was Rangel’s, or whether he was put up to it by someone else.  As one of Hillary’s closest supporters, some have said that it’s a trial balloon on her behalf.  Relatively few in Rangel’s Harlem district will care if a new tax is enacted on the “wealthy,” so he has little to lose by sponsoring this legislation.  However, Hillary could be testing the tax increase waters through a surrogate so that she won’t be labeled as a “tax and spend” Democrat during the election.

As a practical matter, most political analysts see no chance of this legislation ever becoming law.  After all, it would have to overcome stiff Republican opposition, and not even all Democrats agree with it.  Plus, Bush would certainly veto the bill.  However, it might give us some insight into what kind of tax policy we would see if Hillary or any of the other Democratic contenders is elected president.

If Rangel’s Mother of all Tax Hikes becomes law, there will be millions of middle class Americans - those individuals making over $150,000 and couples making $200,000 - who will not only be surprised, but will also finally understand that they were misled by the liberals.  Even though Rangel’s tax proposal is not likely to make it into law this time around, if Hillary or Obama win the White House next year, I predict it won’t be long before we see something like Rangel’s Mother of all Tax Hikes, or maybe something even worse.  Let’s hope not!

Best regards,

Gary D. Halbert

SPECIAL ARTICLES

The Mother of all Tax Hikes, by Dick Armey
http://www.freedomworks.org/newsroom/media_template.php?issue_id=3700

Rangel plans is a Reaganomics Reversal
http://www.usnews.com/blogs/capital-commerce/2007/11/3/a-reaganomics-reversal.html

Dick Morris – Hillary Can Be Stopped in Iowa
http://www.newsmax.com/morris/?s=al&promo_code=3C6E-1

The wrong fix for the housing/subprime problem.
http://www.opinionjournal.com/editorial/feature.html?id=110010826


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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