Today ends the first quarter of 2021. For value equity investors, it was one of the best quarters in years. For tech investors, it was one of the worst. If you chose to play around the speculative fringes of the market, it started out with a bang and ended with a whimper. Meanwhile interest rates at the long end of the curve rose steadily. The 10-year Treasury yield, which started the year under 1%, got up above 1.75% during yesterday’s session, helped by robust government spending and ongoing bond purchases by the Fed and other central banks.
Today President Biden is expected to announce a new spending package that could exceed $2 trillion. There should be at least one or two more packages coming in the months ahead. While the first spending stimulus package quickly gained the unanimous support of Democrats and sailed through Congress quickly, what comes next will follow a more problematic road. For one, despite the thoughts of some progressive members of Congress, spending isn’t free. While Congress over recent decades hasn’t been as successful raising revenues as it has been spending money, any proposed packages have to be paid for in part. That means raising taxes. That means telling constituents that they have to pay more to the government. One can spin the story saying only the rich will pay or that the spending is urgently needed, but in the end, voters will hold their Congressman or Senator accountable at the next election. The old saw is that Republicans like to spend less and Democrats like to tax more. There is truth to that. But, as we saw during the Trump administration, Republicans can spend with the best of them. And no one is thrilled about raising taxes.
With that said, Biden is going to ask for a lot. It is highly unlikely he will get everything he wants. It is doubtful that he will get Democrats to agree on the whole package. Today’s request and those to come should be viewed, therefore, as a wish list. What isn’t included won’t suddenly appear under the Christmas tree.
Clearly, some of what is asked for is needed. Virtually everyone accepts that our roads, bridges, and airports need significant upgrading and repair. At the same time, an economy expected to grow at least 6-7% in real terms this year hardly needs more rounds of stimulus checks. Clearly, there are parts of the economy that aren’t keeping pace. Record stock prices happen while food pantries run out of supplies. But the problem isn’t lack of money, it’s how it is spread around. That sounds like it calls for a Robin Hood solution. Take from the rich and give it to the poor. But history shows that governments are inefficient when it comes to reallocating capital. Indeed, what works best in a capitalist society is the creation of economic incentives that shift the flow of capital. Take the idea of a carbon tax. Those who create greenhouse gases (e.g., fuel inefficient cars or coal-powered generation facilities) pay a tax while those products that are environmentally friendly (solar panels) receive offsetting credits. The notion of a carbon tax is not to raise money for the government, it’s to incentivize all of us to be more environmentally conscious. So why isn’t that on the table? Because a carbon tax is a tax. Those who would have to pay object. Raising gasoline taxes to pay for better roads is criticized for similar reasons.
With all this said, if any significant part of Biden’s spending request becomes law, there will be higher taxes. The most logical to pass include an increase in the corporate tax rate back to 25% (it could go as high as 28%, but not back to the pre-Trump 35%), moving the top bracket for those earning $400,000 to 39.6%, and eliminating the ability to step up the cost basis of inherited assets. Again, there will be a laundry list of other proposals, ranging from changes in capital gains tax accounting to lowering the estate exemptions. But these will have a harder time passing. Focusing on the rich makes some political sense, since most of the taxes raised will come from a tiny fraction of the electorate. But that tiny fraction also pays much of the costs for candidates running for elections. The conflict is obvious.
So, what does one do? First, let’s hear what Biden says. Then let’s see the immediate reaction. Some requests will clearly be dead on arrival. Others will be massaged and altered quickly. For instance, I think the notion of a corporate tax rate of 28% will fade quickly and settle at 25%. If businesses make less, they hire fewer people or move jobs offshore. Another controversial issue will center around requests from legislators from states like New York and California to reinstate the deductions for state and local taxes. The problem with that idea is two-fold. First, that would reduce Federal revenues, not increase them. Second, there are Democratic Senators from low tax states who would oppose such a move. Remember, without Republican support, every Democrat has to agree on any tax package.
Once the dust starts to settle, we will be ready to make decisions and recommendations. Estate lawyers will be very busy. Intergenerational gifts likely will increase. That’s just one impact. Talking with your investment advisor, estate lawyer and accountant will be prudent. Today, however, the answers are probably too opaque to be of much help. That could change quickly in the days ahead.
As for the market, as we enter the second quarter, some of the speculative nonsense we saw in the first quarter seems to be fading a bit. New SPAC offerings aren’t exploding as they were a few weeks ago. But it isn’t gone. Bitcoin prices are still in the stratosphere. Later in the week we will get a slew of economic data to support the premise that our economy is recovering quickly. Earnings season is around the corner. What we want to watch for is whether expectations will increase further as companies report. While the economy is accelerating, investors expect rapid recovery. That is already built into stock prices. Will supply chain disruptions and the Suez Canal blockage throw a monkey wrench into investor dreams? We will be a lot smarter in a few weeks.
Today, Al Gore is 73. Christopher Walken turns 78. Shirley Jones is 87.
James M. Meyer, CFA 610-260-2220