Washington games and their consequences for risks, taxes, stimulus and investing

There is an old house with a box of dynamite in the attic.

Every few years, for as long as anyone can really remember, the children of the house have brought the box downstairs and played games with its contents.?The owners have never seemed very concerned – after all, so far, it has never exploded.?But each generation of kids seems just a little more reckless and irresponsible than the last and it takes just one mistake……

The house is the federal government.?The dynamite is the debt ceiling. And over the next few weeks, this dangerous game will, once again, be played out in Congress.?In addition, even if Congress again raises or suspends the debt ceiling without incident, related decisions will impact the tax code, the extent of fiscal stimulus and the investment environment.

Starting with the dynamite, the federal debt ceiling was first established in 1917 and has been raised or suspended 57 times over the last 50 years.?The most recent suspension of the debt ceiling ended on July 31st?of this year, when it was set at the outstanding federal debt at that time, that is, $28.5 trillion.?Since then, Treasury Secretary Janet Yellen has been using the conventional bag of accounting tricks to pay the bills, including running down the Treasury’s once considerable balance in its checking account at the Fed [1].?Last week, Secretary Yellen updated Congress on the situation, warning that her ability to maneuver below the debt ceiling will likely be exhausted by mid-October.?This would threaten normal government payments and potentially trigger a catastrophic default on U.S. government debt.

One possible solution is to eliminate the debt ceiling immediately and forever.?There is no evidence that this limit has slowed the growth of government debt over time and the focus on this issue diverts attention from the more relevant questions of how much the federal government should be raising in taxes and from whom, and, how much it should be spending and on what.?

However, the debt ceiling has, yet again, become a?political battle. Senate Minority Leader Mitch McConnell has stated that there will be no Republican votes to raise it [2]?and House Speaker Nancy Pelosi has refused to raise it as part of the reconciliation bill which, technically, would require only Democratic votes [3].?It currently appears that Congressional Democrats may include an increase in the debt ceiling in a continuing resolution to keep the government open beyond September 30th.?This procedure would need at least 10 Republican votes in the Senate and, no doubt, Republicans will not want to be blamed for a government shutdown.?However, they may be willing to do so, as a way of embarrassing the Administration and impeding the Democrats agenda.?

There are, of course, multiple risks associated with this brinksmanship and investors will need to pay attention to this issue over the next few weeks.

However, even if the government remains open, the debt ceiling is lifted and the infrastructure and reconciliation bills are passed, the decisions made in getting to these deals will have important implications for investors.?

One very direct issue is taxes.?

On Sunday, House Democrats circulated a plan to fund, or mostly fund, their proposed $3.5 trillion in spending in the reconciliation bill.?The suggested provisions include:

• Raising the top marginal income tax rate from 37% to 39.6%, with the top bracket starting at $400,000 for individuals and $450,000 for married couples, and adding a further 3% surtax on individuals with income over $5,000,000.
• Increasing the top capital gains tax rate from 20% to 25%.
• Cutting the estate tax exemption for married filers from $24 million to $12 million.
• Raising the corporate income tax on domestic income from 21% to 26.5% and on foreign sourced income from 10.5% to 16.5%.
• Adding additional revenue from higher tobacco taxes, limitations on loss carryforwards and tougher IRS enforcement.

Democratic Senator Ron Wyden, the head of the Senate Finance Committee, has also released proposals which include a 2% tax on stock buybacks and increasing taxes on partnerships.?

However, as a practical matter, the Democrats need 50 votes in the Senate to pass any tax increases and, consequently, need the vote of Senator Joe Manchin.?On Sunday, Senator Manchin reiterated that he was only in favor of raising the corporate tax rate to 25% and appeared to favor a bill which raised between $1 and $1.5 trillion in revenue as opposed to the $2.6 trillion in the House Democrat proposal.?

If a compromise is reached, it would presumably be a little less impactful on the economy than the House Democrat proposal.?In addition, capital gains tax changes may well be made retroactive to the “date of announcement”, as suggested by the Treasury Department, which would presumably eliminate the risk of massive selling in advance of higher capital gains tax rates.?However, higher corporate income taxes would tend to reduce the value of stocks relative to bonds and roughly similar increases in capital gains and income taxes for the rich would reduce the value of all financial assets for them.?Higher U.S. corporate taxes would also, of course, reduce the value of U.S. stocks relative to their international counterparts.

Another, broad implication of the negotiations in Washington concerns fiscal stimulus.?

In their July update, the Congressional Budget Office estimated a federal deficit of almost exactly $3 trillion or 13.4% of GDP for fiscal 2021 which ends in 17 days.?They further estimated that this deficit would fall by $1.85 trillion to $1.15 trillion or 4.7% of GDP in fiscal 2022.?Even with some lagged effects of earlier Washington payouts, this implies a very significant drop in federal support for the U.S. economy.?In early August, the CBO also estimated the impact of the proposed infrastructure bill.?These numbers suggest no significant economic impact in 2022.?Consequently, if the economy is going to see further fiscal stimulus over the next year, it will have to come from the reconciliation bill.?

However, there are limits to how much stimulus can actually come from this bill.?Both Senator Manchin and Arizona Senator, Kyrsten Sinema have said that they will not support spending $3.5 trillion.?

The endgame in these negotiations is very unclear.?However, the broad fiscal consequences are not as difficult to draw out.?The key is to recognize that the $5.3 trillion already allocated to battling the pandemic was all?short-term money?while the bills working their way through Congress have taxes and spending spaced out over many years.

Suppose, for example, the final deal is a bill containing $2.5 trillion in spending, partially financed by $1.5 trillion in tax hikes over 10 years.?Even if we assume that all the spending is compressed into five years and that the tax hikes are spread out over 10, this would imply roughly $500 billion in higher spending and $150 billion in higher taxes over each of the next five years – or net fiscal stimulus of $350 billion per year.?This is still small potatoes relative to a projected $1.85 trillion decline in the deficit between this fiscal year and next, absent any legislation.

Since the start of the pandemic, Washington has been the American investor’s best friend.?The Federal Reserve first stabilized markets and then maintained long-term interest rates at super-low levels through massive bond-buying.?Fiscal support has been even more impressive, as both Republican and Democratic lawmakers have funneled cash to American families and businesses.?

However, as we look forward to 2022, the Washington winds are turning.?We expect the Fed to use their early November meeting to announce a plan to taper bond purchases starting in December.?In addition, even if political brinksmanship does not result in a government shutdown or a debt-ceiling crisis, the bills that land on President Biden’s desk will likely contain little further stimulus.?Moreover, a large chunk of the revenues in these bills will likely come from corporations or taxes on the investment income of richer households.??

While it is impossible to predict the timing of any market reaction to all of this, it does suggest a much more challenging environment overall.?If and when this results in a market correction, the hardest-hit assets will likely be those whose valuations have soared the most over course of the pandemic.?As Washington works through its menu of fiscal and monetary choices for 2022, investors may want to embrace assets, such as value stocks and international equities, whose prices will look more reasonable in a clearer but colder policy environment.?

[1]At its peak in July 2020, this amounted to almost $1.8 trillion.?By last Wednesday, this had dwindled to just $201 billion.?

[2]See “McConnell vows no GOP help with debt ceiling”.?Politico, August 5th, 2021.?

[3] See, “Pelosi says raising the debt ceiling won’t be part of reconciliation package”, CNN, September 8th, 2021.

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