A Tax Barbell
David R. Kotok
Cumberland, January 10, 2013

 

Washington has handed an economy now struggling to get back on its feet a barbell instead of a helping hand—a tax barbell.  With much hoopla and political posturing, the United States’ political leadership raised the income taxation on the “rich,” as the White House likes to call them.  But without a word, the White House and the Congress also raised income taxation on the working poor and lower middle class.  That is the effect of the payroll tax (2%) hike.

We believe the impact of this tax increase will be a lower economic growth rate for the US than would have been possible if no income tax rate and no payroll tax rate changes had occurred.  How much slower is subject to debate, but nothing in the so-called Taxpayer Relief Act affords an iota of relief to anyone who works.

Let’s focus on the lower end of the income scale, the working population with incomes in five figures.  In our view these taxpayers were hit hard.  Since most of their incomes are spent on non-discretionary consumption, they will likely invade savings or lower their savings rates in order to sustain themselves.  Collectively, they have been hit with a $120 billion annual tax hike.  That is nearly $1000 for every working person in America.

An analogous situation might be a spike in the price of gasoline.  Let’s use that to demonstrate the impact of the payroll tax.

Suppose the price of gasoline jumped from $3.50 per gallon to $4.50 in one day and stayed at $4.50 for an entire year.  How would we react as Americans? We would see the price at the pump as a continuous reminder of the change in our circumstances.  We would witness the nightly news reporting this change.  We would be livid with politicians, clamoring for them to act.  Those are the same politicians who were silent a few days ago.

The essence of the question is Americans’ behavioral response to a change in economic circumstances.  Are we going to see it 2013?  The macro numbers would say the answer is yes.  Roughly, a penny per gallon change in the gasoline price equates to about $1.2 billion in consumption expenditures per year for American consumers. If we have just imposed a two percent tax on the earned income of most Americans, we have essentially imposed the equivalent of a gasoline price hike of $1 per gallon.

What this taxation change means is that the growth rate of the US economic recovery will be slowed measurably.  There are models which incorporate the economic growth rate, the population change, and the labor force participation rate. Put them to work, and the result of this barbell taxation is to extend the period needed before the US economy will reduce the unemployment rate to the Fed’s target of 6½%.

In other words, President Obama’s noisy attack on the rich also silently punched out the working poor.  But Obama did not do it alone.  The Democrats and the Republicans in the House and the Senate were complicit.  How many did we hear or see defending the working population whose incomes are $100,000 a year or less?

Robust recovery is now less likely in the near future. That is especially true because of the abject failure of the White House and Congress to extend, or make permanent, the 2% reduction in the payroll tax.

Cumberland continues to expect a slow, gradually recovering economy. That will continue for a number of years. Interest rates will remain low, although they may be volatile, as we can see in the bond market’s response to the Federal Reserve minutes. That structure is bullish for the US stock market. Bond portfolios can use hedging techniques to mitigate some of the volatility in interest rates.

Also note the Labor Department estimates of about 460,000 folks counted as employed because the states are paying subsidy to keep the jobs rather than have the person seek unemployment benefits (source: Bloomberg, January 10).  The effect is to distort the reported unemployment rate downward because those folks remain “employed”.  We are not opposing the policy.  We are just noting that the Fed’s target of a 6 ½% unemployment rate may need to be examined for these changed circumstances which are not in the historical data.  This revelation is additional support for our view that the period of low interest rates and ongoing Fed QE policy is longer than markets currently expect.

We are scheduled to appear on Bloomberg TV with Trish Regan for the whole hour on Tuesday, January 15 from the 3 to 4 PM (EST).  We hope to discuss this reduction of growth due to taxation and what it means for the extended period of low interest rates.

~~~

David R. Kotok, Chairman and Chief Investment Officer

Twitter: @CumberlandADV

Cumberland Advisors

 

Category: Taxes and Policy, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

13 Responses to “A Tax Barbell”

  1. mathdock says:

    Am I mistaken, or isn’t the return of the Social Security 2% break important to the assumptions of when the excess funds are gone? It would seem that the duration of the fund’s surplus would be reduced by 12% if not for restoring the break. It would also imply a further 12% reduction in available funds for benefits once the excess funds are expended, no?

    I agree that the working poor and unemployed receiving benefits are whacked, as well as Social Security recipients below the poverty line, since these folks have no spare fat to cut in their lives. Without reducing the population of beneficiaries by some signficant amount(via means-testing), it’s hard to see this not blowing up much worse in 7 to 12 years, depending on whose projections you choose to believe.

  2. rd says:

    Is FICA a tax or a contribution to a pension plan? It seems like both political parties want it both ways.

    There has been lots of argument about whether or not the part of the population that works but does not pay income tax are takers because they don’t pay federal taxes. That appears to be an argument that FICA is a pension plan contribution. However, the same people then argue that the rich should not have their income taxes raised in order to fund Social Security that benefits the low and middle-income groups – however, Social Security is not being funded by the income tax from the rich so this has been a very confusing argument that has been grossly uncovered by the media.

    It was truly bizarre that much of the income tax debate centered around potential cuts to Social Security instead of things like defence, etc. that are actually paid for by income taxes. My biggest concern with extending the payroll tax holiday for too long was that it would start to cause problems with Soical Security funding projections that could then be turned into real cuts.

    We did miss a huge opportunity to greatly simplify the tax system since its complexity is a drag on the economy. As long as the capital gains/dividends went up to the levels in the agreement, I would have gladly given up the 35% to 39.6% ordinary income tax rate increase in order to eliminate many of the loopholes, deduction, and tax credits that make the tax system inordinately complex.

    ~~~

    BR: Its supposed to be more like a payment into an insurance plan

  3. wally says:

    Government spends the money it collects. The assumption that it is somehow taken out of the economy when it is collected as a tax is simply wrong… and so are any conclusions based on that assumption. Government pays employees and buys goods just as any other employer. Redistribution is not the same as destruction.

  4. Non Sequor says:

    Elaborating on what BR said, SS is not supposed to be a retirement plan so much as an insurance plan that health works pay into and people who are too old or too disabled to work receive payments from.

    FDR’s reason behind funding it with a payroll tax on covered income was so that anyone who had made contributions into the system had a claim to the benefit associated with those contributions. It’s intended to be difficult to dismantle social security without convincing people that their benefit isn’t a byproduct of contributions.

    Any changes to social security need to be made with an awareness of what workers are supposed to be giving for heir coverage and what product beneficiaries are supposed to be receiving. If you break down the quid pro quo aspects of the system, it will morph into a welfare program that Randians will have a much easier time dismantling.

  5. Frilton Miedman says:

    Excellent observations, the economic loss from the payroll tax hike won’t be offset by the revenue increases for $400+ incomes, not when nothing is done for demand.

    It’ll help the national debt, sure, but that’s it….increasing (or at least maintaining) demand would do a lot more for the debt and simultaneously boost the economy.

    I’m self employed, I’ll see it first-hand.

    The proportion of my client base income levels mirrors the whole, meaning that 98% of my customers now have less disposable income.

  6. Disinfectant says:

    Wally, you are incorrect. Government spending is not tied to tax collections; the government borrows additional funds needed for spending. The government will spend $X this year no matter what the revenues are, so increasing taxes will reduce spending.

  7. Frilton Miedman says:

    Non Sequor Says:
    January 10th, 2013 at 4:58 pm
    “… If you break down the quid pro quo aspects of the system, it will morph into a welfare program that Randians will have a much easier time dismantling.”

    ~~~

    The problem with Randian/Austrian thinkers, they don’t understand (or want to) the nature of progressive taxation and the effects of flat taxation on consumption within natural wealth disparity of a capitalist economy.

    A 2% tax increase to 98% of the lower income population equates to far more loss in disposable income and consumption than a 5% increase to the top 2% who spend far less of a proportion of their income.

    A $100K Italian sports car amounts to 10% of the income of a million dollar salary,

    while a $25K economy car accounts for 50% of the median income (@ $50K), it’s same premise on taxation..

    Without at least some understanding or acknowledgement of this, there’s no discussion at all with the Laissez-faire crowd.

  8. emaij says:

    Ya, tax zaps demand. Gov’t spending is based on the whims of Washington and is not related to taxation at this point and time.

  9. victor says:

    Payroll taxes have been unchanged since approx. 1990, see:

    http://en.wikipedia.org/wiki/File:Historical_Payroll_Tax_Rates.jpg

    The continued graying of our population, due to modern means of prolonging life plus low fertility rates at the other end guarantees future increases to be levied on employees and employers.

    BTW I too was surprised that Hotok failed to mention that this “increase” is just a return to the latest rates of 2 years ago. And he should lose his penchant for predicting interest rates.

  10. Mattw says:

    Is it a smart idea to listen to economists who are a part of a professional where there is little or no penalty for being wrong? And you expect greatness from that?

    What about the politicians?

    Unfortunately, everybody thinks our current mess is economic. It’s actually an accumulation of bad ideas, bad decisions and corruption. No crash means all this crap stays in place. It also means a continuation of stupid ideas coming out of Washington.

  11. constantnormal says:

    How did the US ever survive the decades in which the tax rates were sooooo much higher than they are today?

    It seems. looking back at what actually happened, that we not only survived, we prospered.

    Taxes have very little to do with the economy, the taxes to businesses will be passed along to their customers, limiting the effective additional tax bite to the folks who actually buy that company’s products. And the taxes to the wealthy seem to have not impacted anyone’s desire to become wealthy, nor the wealthy’s life style differential.

    Unless I am misreading my history, back when we had a 90% tax rate on the top incomes, we were regarded a a “rich” nation, and people were clamoring to come here to live and work, in hopes of making enough to merit such a heavy tax load.

    Perhaps, to become economically “stronger”, we need to train with beefier barbells …

  12. Greg0658 says:

    constantnormal from 0956a – I am in agreement with the sentiment .. imo the desires are to repossess all possible under the current rough waters to resell back in the better days that must come for capitalism to work again – another version of wash rinse repeat

    but don’t wash away the issue of: to many humans desire’g to few jobs – devoure’g food & fuel

  13. victor says:

    @constantnormal: you say ” Taxes have very little to do with the economy”.. you’re kidding right?