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Investment Outlook - Third Quarter 2017

Tax Reform Thoughts


By: Denny Fulmer, CFA
Thursday, December 14, 2017

Investors are having serious doubts that tax reform will actually happen since efforts to repeal and replace the Affordable Care Act failed. Recently, the administration has released an outline of preferred changes, with the biggest modification being a reduction in the corporate tax rate. Since we have one of the highest rates among the developed countries, we have seen some across-the-aisle support for lowering corporate taxes. Proposed changes in the personal tax rates appear to be less significant, so perhaps this limited tax change will happen soon and be modestly favorable to the stock market. The word reform implies all-encompassing changes, which would be very difficult. Most pundits believe that the goal of tax reform is to stimulate the economy by lowering the marginal tax bracket. The theory is that high marginal tax rates discourage risky investments and efforts to work harder.


We had a very good tax system implemented in 1986 when the maximum Federal Tax Rate of 28% was coupled with an Alternative Minimum Tax (AMT) Rate of 21%. The AMT is a second or parallel calculation of your income tax that excludes most of the deductions. Consequently, the AMT was very close to a flat rate on all of your income. Supply-side economists credit this tax system for unleashing strong economic growth that lasted for decades when our economy grew faster than 3% per year. From our view as investors, this tax system was so good that it eliminated most of the crazy tax shelter strategies that were popular prior to its enactment. It was a far better strategy just to pay the taxes and invest your remaining income in sound investments rather than try to hide it in a convoluted tax shelter that involved a lot of financial engineering. At the time we write this the new proposal does not include enough detail to identify the beneficiaries, but that has not stopped Chuck Schumer from claiming that it benefits the rich. We are encouraged that President Trump appears to understand the merits of lowering the corporate rate and should be an effective promoter of the changes, unlike his efforts on healthcare reform. 


The consensus opinion of our investment team is that the growth we saw in 1986 will not be replicated since the top personal brackets are more resistant to change and tax reform is unlikely to impact the decisions to either work harder or make more investments. Simplifying the tax code and keeping corporations in the United States is still positive and very important.


The Federal Debt just went over$20 Trillion!


Rather than tax reform, we think the efforts of Congress would be better utilized on spending restraint – particularly entitlement reform. Every dollar that the government spends is taken out of the economy, by taxes or borrowing. The amount of spending is the true total burden of the government. While the tax system should be improved, a higher priority should be reining in the runaway entitlement programs, with Medicare and Medicaid at the top of the list.


J.D. Vance, the author of Hillbilly Elegy, a current bestseller about escaping Appalachian poverty, had many interesting observations. After working in a grocery store and seeing who was getting food stamps, he concluded that the main reason the working class has been leaving the Democratic Party was that they saw too many people living a better life on government assistance than the working class could afford for themselves. We read one article that said the Federal Government funds 126 separate anti-poverty programs and 72 of them provide benefits directly to individuals! This sounds like an area in dire need of reform. Milton Friedman, a famous economist in my formative years, has some thoughtful criticisms of these social programs. They discourage people from getting off welfare and going back to work because the loss of benefits often exceeds what they would make from a job. Friedman passionately describes how this crushes the spirit of the people we are trying to help.They feel trapped and are demoralized from this system and give up trying to rejoin the working population. Perhaps the current protests by some NFL players may relate to how those in the inner city may feel trapped in a system which stifles their freedom.Friedman’s idea of a negative income tax solves this problem, as they would always have an incentive to earn more money. This is because they would keep at least 50% of the additional earned income versus what could be a much higher loss of benefits from the current system. The cost of this system is probably no higher than what we are currently spending. Furthermore, we would not need all of the bureaucrats now employed who are handling the multitude of overlapping assistance programs which exist today. Friedman says the poor simply want more money, not the paternalistic rules and limitations which these programs try to enforce. These rules are often circumvented by the ingenuity of the recipients. For more details on this topic, go to YouTube and search for Milton Friedman.


In summary, people respond to incentives along the continuum of the income spectrum.The vast amount of dollars spent on government policies would be more effective if they take this into account.




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