The Bush-Era Tax Cuts Live On

THE BUSH-ERA TAX CUTS LIVE ON

With the President’s signature, most of them will remain in place through 2012.

A holiday gift for taxpayers? After a 277-148 passage in the House and an 81-19 approval in the Senate, President Obama signed the 2010 Tax Relief Act into law on December 17, extending the Bush-era tax cuts.1 Here is the impact of the new legislation:

Current federal income tax rates are preserved for everyone. The federal income tax brackets will remain at 10%, 15%, 25%, 28%, 33% and 35% for 2011 and 2012.2

Unemployment insurance extends for 13 more months. This is retroactive, so the federal extension of long-term jobless benefits applies from December 2010 through December 2011.2

A payroll tax holiday occurs in 2011. The payroll taxes that employees pay will drop from 6.2% to 4.2% next year. (There will be no payroll tax cut for employers in 2011, only employees.) As envisioned, this will result in a savings of about $1,000 next year for a wage earner bringing home $50,000. This replaces the Making Work Pay credit.3,4,5

Estate taxes will be milder than at any time in the past 80 years. For 2011, the federal estate tax drops to 35%. The estate tax exemption rises all the way to $5 million. President Obama had earlier characterized these parameters as too generous, but he and Congressional Democrats ultimately accepted them.2

Tax breaks for middle-class and working-class families won’t sunset. As a result of the new law, the child credit, the child and dependent-care credit, the EITC, and a $2,500 tax credit for higher education expenses will all be around in 2011.5,6

No marriage penalty. The new law wards off the comeback of the marriage penalty so that married couples may take a more generous standard deduction.6

Taxes on capital gains and dividends top out at 15%. Passage of the 2010 Tax Relief Act means rates will top out at 15% through 2012.7

Businesses may expense 100% of their investments in 2011. In fact, qualified investments made after September 8, 2010 and before January 1, 2012 are eligible for this bonus depreciation. In addition, 50% expensing will be available for qualified property placed in service during 2012, and so-called “long-lived” property and transportation property may be eligible for 100% expensing if it goes into service prior to 2013.7

The tax break for IRA gifts to charity returns. The IRA charitable rollover, as it was informally called, was much beloved by non-profits and IRA owners, but it went away in 2010. In basic terms, it allowed someone 70½ or older donate up to $100,000 in IRA assets annually to one or more qualified charities. This opportunity is back for 2011 – and the especially good news is that Congress included a special rule in the new tax bill allowing IRA gifts made in January 2011 to count for 2010.8

An AMT patch, of course. Congress decided it might as well take care of that. It passed an AMT (Alternative Minimum Tax) fix as part of the 2010 Tax Relief Act, thereby exempting about 20 million middle-income households from a potential $3,900 average leap in federal income taxes.6

What’s the price tag of all this short-term tax relief? It is sizable. The federal deficit is projected to increase by about $858 billion over the next two years as a consequence.5

Citations.
1 - edition.cnn.com/2010/POLITICS/12/17/tax.deal/ [12/17/10]
2 - online.wsj.com/article/
SB10001424052748703296604576005430598327972.html [12/7/10]
3 – npr.org/2010/12/10/131969824/some-worry-payroll-tax-cut-threatens-social-security [12/10/10]
4 – businessweek.com/news/2010-12-10/u-s-tax-vote-may-be-too-late-to-cut-payroll-levy.html [12/10/10]
5 –startribune.com/politics/112046564.html? [12/16/10]
6 –businessweek.com/ap/financialnews/D9K5IEN81.htm [12/17/10]
7 –tax.cchgroup.com/downloads/files/pdfs/legislation/bush-taxcuts.pdf [12/16/10]
8 – online.wsj.com/article/
SB10001424052748703395904576025610771041244.html [12/17/10]
9 – montoyaregistry.com/Financial-Market.aspx?financial-market=roth-ira-rules-and-regulations&category=1 [12/18/10]

What Could A Payroll Tax Cut Mean For Social Security

Would it send the wrong signal at the wrong time?

A claim too good to be true? If the recent agreement on taxes forged between President Obama and Congressional Republicans becomes law, payroll taxes would be lowered by 2.0% in 2011. According to the Joint Committee on Taxation, that would cost the federal government $111.7 billion. The White House claims this drop in tax revenue would have no impact on Social Security’s solvency.1,2

In response, some legislators and analysts are raising their voices, worried that the proposed payroll tax holiday could be a harbinger of unpleasant things to come for America’s retirement program.

How could you pull this off without hurting Social Security? Good question. As Social Security (and Medicare) rely on payroll levies for a great deal of revenue, chopping those taxes down from 6.2% to 4.2% in 2011 would seem to be ruinous.3

The federal government’s answer to that question: reimburse the loss to the Social Security Trust Funds using general revenue. That idea worries Social Security advocates, and it also begs a question.

The “what if” some analysts fear. What if the planned payroll tax cut becomes permanent? It could happen, especially with Republicans in control of the Senate. The EGTRRA cuts were conceived as temporary cuts, and they are starting to seem more permanent with each passing year.

Last week, Sen. Mike Johanns (R-NE), Sen. Bob Corker (R-TN) and Rep. Ted Deutsch (D-FL) all told NPR that they felt Republicans would try to make the payroll tax reduction permanent during 2011. Deutsch warned that a move to fund Social Security with general revenue will hearten "those who [want] to move away from our longstanding, successful Social Security program to privatization and to benefit cuts. It will enable them to make those arguments in a way that they've never been able to make them before."3

Nancy Altman, co-chair of the advocacy group Social Security Works, thinks a lasting cut in payroll levies could end up making Social Security’s shortfall twice as large as it is now. She warned NPR that with the probable extension of EGTRRA and JGTRRA, “we see now that it's very hard once a tax cut is in place to repeal it,” and told USA TODAY that “it's unfathomable that this is going to last only one year.”3,4

P.S.: the 2011 tax break might be less prevalent than assumed. The federal government says a 2% payroll tax cut could provide tax breaks as large as $2,000 in 2011 for American workers. But as Bloomberg Businessweek reported on December 10, any Congressional vote might happen too late for some employers to act. Last year, the IRS notified payroll departments about 2010 tax tables on November 20. We are well past that date.2,3

Incidentally, the envisioned payroll tax cut is for workers only, not businesses. The payroll tax would stay at 6.2% for employers in 2011.2

Citations
1 – online.wsj.com/article/
SB10001424052748703296604576005430598327972.html [12/7/10]
2 – businessweek.com/news/2010-12-10/u-s-tax-vote-may-be-too-late-to-cut-payroll-levy.html [12/10/10]
3 – npr.org/2010/12/10/131969824/some-worry-payroll-tax-cut-threatens-social-security [12/10/10]
4 – content.usatoday.com/communities/theoval/post/2010/12/social-security-backers-blast-obamas-payroll-tax-cut/1 [12/10/10]

REAL Debt Reform

If you want to watch something alarming, look at the U.S. Debt Clock (http://www.usdebtclock.org/), which calculates, second-by-second, America's rising debt (approaching $14 trillion), federal spending (nearly $3.5 trillion a year) and budget deficit (roughly $1.3 trillion). Second-by-second the numbers increase, and you can also watch (more slowly) the inexorable rise in the average debt per U.S. citizen--currently more than $44,000, perhaps more by the time you read this and check for yourself.

The Debt Clock also lists the largest budget items and THEIR growth, and you can quickly see that they are not where most of the politicians have focused their attention and public statements. While incoming Congressional leaders talk about ending earmarks and cutting foreign aid, the back-breaking line items on the federal budget are Medicare/Medicaid, Social Security, Defense and war expenditures. At the bottom of the Debt Clock screen are some truly frightening statistics: add up all the future unfunded liabilities for Social Security, the federal prescription drug program and Medicare liability, and you get a future cost of $111.5 trillion. That's a little over $1 million per taxpayer.

Like any debtor who gets in over his head, the U.S. Congress faces painful choices. They can either make very difficult decisions now--and possibly alienate voters--or kick the can further down the road and leave a bankrupt country or crushing debt for our children or grandchildren to pay. The problem is great enough that a coalition of the very rich, including Bill Gates and Warren Buffet, are doing something unheard of: they are publicly arguing that Congress should end the tax cuts for them and others of the wealthiest Americans.

Is there a way to get both political parties talking about the hard choices? On December 1, a bipartisan National Commission on Fiscal Responsibility and Reform, made up of 18 prominent Republican and Democratic leaders, released "The Moment of Truth," a set of recommendations that would, if enacted, achieve a $4 trillion reduction in government debt. The group includes the chairmen and ranking members of the Senate and House Budget committees, the chairman of the Senate Finance Committee, a former White House budget director and a vice chairman of the Federal reserve board. To achieve their deficit reduction goals, the commissioners put everything on the table--Social Security, Medicare, tax rates, government spending, even the elimination of popular tax deductions.

You can read the full 49-page report here: http://www.cbsnews.com/8301-503544_162-20024235-503544.html. The report lists, on page 10, some of the considerations that went into the decisions, which you may or may not agree with: "We all have a patriotic duty to make America better off tomorrow than it is today;" "Don't disrupt the fragile economic recovery;" "Cut spending we cannot afford--no exceptions;" "Demand productivity and effectiveness from Washington;" "Don't make promises we can't keep;" "Keep America sound over the long run."

The plan would cut government discretionary spending and impose spending caps, including annual limits on war spending, impose 15% reductions in Congressional and White House budgets, a three-year freeze on annual Congressional pay raises, and eliminate all Congressional earmarks (9,000 in FY 2010, costing close to $16 billion).

The commission also recommends lowering tax rates and eliminating many deductions. There are actually several alternatives in the final proposal (pages 25-27), depending on which deductions are eliminated. One possible plan is to bring us down to three tax brackets of 12%, 22% and 28%--replacing five brackets ranging from 15% to 39.6% that is due to take effect in 2011. Corporations would pay at a flat rate somewhere between 23% and 28%, and lose most of their special subsidies and tax loopholes.

To get there, the Commission proposes that Congress eliminate all itemized deductions (everybody would take the standard deduction) and replace today's mortgage interest deduction with a 12% tax credit for mortgage loans up to $500,000. Capital gains and dividends would be taxed at ordinary income rates (rather than the preferential rates under current law) and the dreaded AMT would be eliminated altogether.

More controversially, charitable donations, which are currently deductible for itemizers, would only qualify for a 12% tax credit, and only then to the extent that the gift exceeded 2% of a taxpayer's adjusted gross income. The Commission also proposed replacing the current melange of retirement plans (Roths, IRAs, 401(k)s, 403(b)s, defined benefit plans etc.) with one type of tax-favored retirement account for everybody; the maximum tax-preferred contribution would be $20,000 or 20% of income, whichever is lower.

The commission proposes to raise the age at which you could receive full Social Security benefits by indexing it to life expectancy. The Normal Retirement Age, which reaches 67 in 2027, would go up to age 68 by the year 2050, and 69 by 2075. The Early Retirement Ages, when people could opt for lower annual benefits, would go up to age 63 by 2050 and 64 by 2075. The taxable maximum wage cap on Social Security taxes, currently $106,800, would grow more rapidly than it has in the past, reaching $190,000 in 2020, versus roughly $168,000 under current law.

Finally, the current federal gas tax would be increased by 15 cents per gallon, a figure which is still significantly lower than most European countries. Among a variety of Medicare reforms, the Medicare physician payment formula would be changed to reward quality of care and outcomes, rather than the quantity of visits or procedures. And the government's civilian workforce would gradually be cut by ten percent.

If 14 of the 18 members of the Commission had voted to endorse the recommendations, then the full report would have been sent to Congress for a vote. As it is, only 11 endorsed their own recommendations.

Endorsing: Senate Majority Whip Richard Durbin (D-IL); Senate Budget Committee Chairman Kent Conrad (D-ND); House Budget Committee Chairman John Spratt (D-SC); former Federal Reserve Board vice chairwoman Alice Rivlin, Republican Senators Tom Coburn (OK); Mike Crapo (ID) and Judd Gregg (NH), plus Ann Fudge of Young & Rubicam, and Dave Cote of Honeywell International. Co-chairs Erskine Bowles (former Clinton White House Chief of Staff) and former Republican Senator Alan Simpson also voted for the proposal.

Opposed: Senate Finance Committee chair Max Baucus (D-MT); Rep. Xavier Beccera (D-CA); Rep. Jan Schakowski (D-IL); Rep. Dave Camp (R-MI); Rep. Paul Ryan (R-WI), Rep Jeb Hensarling (R-TX) and Andy Stern of the Service Employees International Union.

Nevertheless, even the dissenting members of the Committee believe it will change the debate in Washington, and focus Congressional attention on the hard choices rather than the easy sound bites. Let's hope so for the sake of our children and grandchildren.


Sources

Market News: http://imarketnews.com/?q=node/23235

Associated Press: http://www.kansascity.com/2010/12/01/2491715/deficit-reduction-committee-issues.html#ixzz16yaiKLmB

Wall Street Journal: http://online.wsj.com/article/SB10001424052748704594804575648503541856136.html

Tax us more: http://abcnews.go.com/ThisWeek/billionaires-buffett-gates-tax-us/story?id=12259003

Votes pro and con: http://www.miamiherald.com/2010/12/03/1955486/debt-commission-majority-endorses.html

You, Too, Can Balance the Federal Budget

Want to have a little mindless fun? Try balancing the federal budget in ten minutes or less.

Believe it or not, you can actually do this on an interactive web site created by the New York Times. (You can find it here: http://www.nytimes.com/interactive/2010/11/13/weekinreview/deficits-graphic.html) There are two graphics at the top of the page: one is the projected shortfall in 2015 (a scary $418 billion), and the other is a more long-term (and scarier) deficit in 2030 ($1.345 trillion).

To reduce those numbers, you make hard choices. You can cut foreign aid in half, eliminate all farm subsidies, cut the pay of civilian federal workers by 5 percent, reduce the federal workforce by 10 percent, reduce the military to pre-Iraq War size and reduce troops in Asia and Europe, reduce the number of troops in Iran and Afghanistan to 30,000 by 2013 (or make more modest cuts), raise the Social Security retirement age (there are two options), modify estate taxes, reduce or eliminate the Bush tax cuts, or impose a national sales tax and/or carbon tax.

And more. With each box you check (each cut you make or tax you raise), you see how much progress you're making on the overall budget deficit in 2015 and 2030. The choices are not easy ones, and you quickly discover that the "fixes" most often debated on both sides of the aisle in Congress won't make much of a dent.

Unfortunately, there isn't a button on the web site that you can push to make these deficit reduction provisions actually happen in the real world. But having an easy, interactive tool like this will undoubtedly help raise awareness, among the people who don't deal with these budget numbers on a daily basis, about the kind of measures that will have to be taken if we don't want to leave our children and grandchildren with a ton of federal debt to pay off. You'll probably remember this little game next time you hear a politician talking tough about eliminating debt in Washington.

Federal Money Supply

A warning shot

You may have heard recent controversy over the U.S. Federal Reserve Board buying Treasury bonds--$600 billion in all--and wondered what all the fuss was about. You may even have wondered why one branch of the government is buying bonds from another one.

The headlines say that this is a "stimulus" measure, which basically puts more money into the U.S. economy without costing the taxpayers anything. This is true, up to a point; buying Treasury securities means the central bank is essentially creating new money. Other analysts say that creating new money is inflationary, which also tends to be true. However, the Stratfor Global Intelligence service has pointed out that creating $600 billion over eight months is not dramatically more than the Fed's normal actions in managing the money supply, and with $8 trillion in circulation (the M2 money supply figure, which does not include CDs and institutional money market fund balances), dollars are not going to suddenly become dramatically more plentiful. And in a $14.3 trillion economy, the stimulus is not likely to turbo-charge the next round of employment figures. It probably won't even show up in GDP.

So what gives? Looking at the global economic picture, right before the G20 economic summit, Stratfor notes that export nations like Japan and Germany have linked their recovery hopes to selling more to U.S. consumers. The more they sell, the more they drive up the difference between U.S. imports and exports--or, in economic terms, widening the current account deficit and diverting money from our economy into theirs. To do this most effectively, they need their currency to be weaker than the dollar so that their manufactured items look like a bargain. Stratfor notes that Japan has been openly intervening in currency markets to drive down the yen. Germany, meanwhile, doesn't have to: it has benefited from a weakened euro--the result of well-publicized debt problems in Greece, Spain, Portugal and most recently Ireland. An article in the November 5 issue of the Wall Street Journal says that not only Japan, but also Brazil and South Korea have taken actions to depress their currencies against the dollar.

Seen in this light, the Fed's action can be seen as a warning to the other nations that the U.S. is capable of protecting its currency and export industries from these raids on its economy. The $600 billion purchase probably won't affect the value of the dollar, but they show that the Fed is well aware of the actions of the other countries. As U.S. representatives negotiate to stop currency manipulation at the G20 summit, the rest of the world knows that if there is no agreement, the U.S. is capable of fighting back. Sure enough, The Wall Street Journal quoted finance ministers and economists from Brazil, France, South Korea and Germany, all criticizing the purchase and calling for a cease fire in the currency wars.

Should we worry about inflation as these negotiations drag on? At a time when the worst-case economic scenario is deflation, a few small nudges in the inflation rate might not be the worst thing to befall the U.S. economy; today's rate is well below the 2% target informally set by the Fed. Should we worry about a falling dollar? If you're traveling abroad, or buying a foreign car, then you might have to pay a bit more if the dollar weakens against the currency of the nation you're traveling to or where the car was made. But foreign stocks, bonds and mutual funds are always a little more valuable--in dollar terms--whenever the dollar declines in value, so your international holdings could get a small boost in return.

But the most likely scenario is that the Fed's demonstration will keep everybody at the negotiating table. And you'll continue to hear the conventional interpretation: that this is all about stimulus back home--which, to the extent that it keeps other countries from raiding our economy, it is.


Sources:

Stratfor analysis: http://www.stratfor.com/memberships/175231/geopolitical_diary/20101103_washingtons_warning_shot_currency_front

U.S. money supply: http://en.wikipedia.org/wiki/Money_supply

Size of the U.S. economy: http://en.wikipedia.org/wiki/Economy_of_the_United_States

Wall Street Journal articles about the Fed's repurchase: http://online.wsj.com/article/SB10001424052748704353504575596203544367856.html

and: http://online.wsj.com/article/SB10001424052748704327704575614853274246916.html?mod=WSJ_article_MoreIn_Economy

Your Annual Financial To-Do List

Things you can do before and for the New Year.

The end of the year is a good time to review your personal finances. What are your financial, business or life priorities for 2011? Try to specify the goals you want to accomplish. Think about the consistent investing, saving or budgeting methods you could use to realize them. Also, consider these year-end moves.

Think about adjusting or timing your income and tax deductions. If you earn a lot of money and have the option of postponing a portion of the taxable income you will make in 2010 until 2011, this decision may bring you some tax savings. You might also consider accelerating payment of deductible expenses if you are close to the line on itemized deductions – another way to potentially save some bucks.

Think about putting more in your 401(k) or 403(b). You can contribute up to $16,500 to these accounts in 2010, with a $5,500 catch-up contribution also allowed if you are age 50 or older. Has your 2010 contribution approached the annual limit? There is still time to put more into your employer-sponsored retirement plan.1

Can you max out your IRA contribution at the start of 2011? If you can do it, do it early - the sooner you make your contribution, the more interest those assets will earn. And if you haven’t made your 2010 IRA contribution yet, you can still do so through April 15, 2011.1

The 2011 contribution limits on traditional and Roth IRAs are unchanged from 2010. You can contribute $5,000 to your IRA next year if you are age 49 and below, $6,000 if you are age 50 and above.2

Consider a Roth IRA conversion before 2010 ends. Now anyone may convert a traditional IRA to a Roth IRA; there are no longer any income limits in the way. If you pull off a Roth conversion before 2010 ends, you can choose to divide the taxes on the conversion between your 2011 and 2012 federal returns. This nice opportunity won’t be available if you make a Roth conversion in 2011.1

There are still MAGI phase-out limits for contributing to Roth IRAs. For 2010, those limits kick in at $167,000 for joint filers and $105,000 for single filers. If your MAGI will exceed those limits, you still have a chance to contribute to a traditional IRA in 2010 and immediately roll it over to a Roth.3

Consult a tax or financial professional before you make any IRA moves. You will want see how it may affect your overall financial picture. The tax consequences of a Roth conversion can get sticky if you own multiple traditional IRAs.


If you are retired and older than 70½, don’t forget the 2010 RMD. As your IRA custodian has undoubtedly reminded you, the one-year suspension of Required Minimum Distributions has been lifted. Retirees over age 70½ must take RMDs from traditional IRAs - and 401(k)s - by December 31. Remember that the IRS penalty for failing to take an RMD equals 50% of the RMD amount.1,4

If you have turned or will turn 70½ at some point in 2010, you can choose to postpone your first IRA RMD until April 1, 2011. The downside of that is that you have to take two IRA RMDs next year – you have to make your 2010 tax year withdrawal by April 1, and your 2011 tax year withdrawal by December 31.1

Keep an eye on what happens with income, capital gains & estate taxes. We’re all watching and waiting here to see what Congress will do.

If Congress doesn’t extend the current law, the tax rates on long-term capital gains will go from 0% to 10% next year for those in the 10% and 15% tax brackets. Taxpayers in higher brackets will see their capital gains tax rates rise 5% in 2011 to 20%. In addition, dividends are scheduled to be taxed at marginal income rates of 39.6%. As it stands now, time is running out to take advantage of the current capital gains tax break.5

Income taxes are poised to return to pre-EGTRRA levels in 2011, with the lowest bracket set at 15% and the highest bracket set at 39.6%. (The so-called “marriage penalty” would also come back.) No one in Congress wants this on their legacy, so some kind of extension of the Bush-era tax cuts will almost certainly be worked out. We will have to wait and see if Congress extends the cuts for all or simply for the middle class.6

Estate taxes will undoubtedly return in 2011. Hopefully, Congress will prevent them from returning at the 2001 levels (a puny $1 million exemption and a 55% top tax rate).6

You may wish to make a charitable gift before New Year’s Day. If you make a charitable contribution this year, you can claim the deduction on your 2010 return.

You could make December the “13th month”. Can you make a January mortgage payment in December, or make a lump sum payment on your mortgage balance? If you have a fixed-rate mortgage, a lump sum payment can reduce the home loan amount and the total interest paid on the loan by that much more. In a sense, paying down a debt is almost like getting a risk-free return.

Are you marrying next year, or do you know someone who is? The top of 2011 is a good time to review (and possibly change) beneficiaries to your 401(k) or 403(b) account, your IRA, your insurance policy and other assets. You may want to change beneficiaries in your will. It is also wise to take a look at your insurance coverage. If your last name is changing, you will need a new Social Security card. Lastly, assess your debts and the merits of your existing financial plans.

Are you returning from active duty? If so, go ahead and check the status of your credit, and the state of any tax and legal proceedings that might have been preempted by your orders. Review the status of your employee health insurance, and revoke any power of attorney you may have granted to another person.

Don’t delay – get it done. Talk with a qualified financial or tax professional today, so you can focus on being healthy and wealthy in the New Year.

Could QE2 Lead to Bubbles?

Why some analysts are worried about the Fed’s latest monetary easing effort.

Is the glass half full? The Federal Reserve has committed to buying $600 billion worth of Treasury bonds between now and June, and it wants to purchase up to $900 billion in debt by the end of September 2011.1 This second round of quantitative easing has been dubbed QE2. In a nutshell, the effort would pour cash into the banking system to promote lending and inflation, and it has the potential to help stocks, the housing market and consumer spending.

Or is it half empty? Some economists are worried about the impact of this tactic. They fear it may create a stock bubble – an inflated equities market motivated by speculation and low interest rates instead of earnings. Likewise, some see a commodities bubble that could burst dramatically in the years ahead.

QE2 has already earned some prominent detractors. Bond market guru Bill Gross just called it “a Ponzi scheme” that will end the 30-year bull market in bonds (an event he has actually forecast for some time). Jim Rogers, the Quantum Fund co-founder who astutely called the worldwide bull market in commodities in 1999, recently labeled QE2 “petrol on the fire” of the commodities market and told an Oxford University audience that Fed chair Ben Bernanke “does not understand economics … all he understands is printing money.”2,3

Will more investors turn to stocks? The Fed’s bond-buying program implies lower long-term interest rates, lower bond yields and a weaker dollar. In an environment with lower bond yields, investors are predisposed to enter other asset classes such as real estate and stocks. If the stock and housing markets improve, that will certainly aid consumer confidence which, in turn, should aid consumer spending.

On Main Street, there are two speed bumps on the way to that rosy domestic outcome: a lack of customers and/or demand (especially in the housing market) and unemployment. The Fed’s strategy may have a tough time getting around those economic obstacles.

Why are other nations growing testy? QE2 could invite a trade war. A weak greenback means a big advantage for U.S. exports. Our products will be cheaper in other nations thanks to the increase in the money supply holding down the value of the dollar. Correspondingly, imported goods will cost us more and we will buy less of them. That’s terrible news for nations such as China, Germany, Russia, Japan, France, Great Britain and Hong Kong – all of whom are counting on exports to aid in their economic recoveries.

If U.S. interest rates are too low for too long, investors may try the emerging markets and/or the commodities markets seeking higher returns. So the commodities markets and the emerging markets could get even hotter.

If that happens, it would imply higher prices for oil, crops and raw materials in the United States, which would hamper our economy. Of course, many analysts think the commodities markets will keep advancing with or without influences like QE2 – the ongoing condition is simply too much demand and not enough supply.

Is this the “Hail Mary” play? With interest rates so low and one round of bond-buying already in the history books, the Fed doesn’t have many options left to jump-start the economy. Here’s hoping its latest move gives the recovery more traction.


Citations
1 – money.cnn.com/2010/11/03/news/economy/fed_decision/index.htm [11/3/10]
2 - blogs.wsj.com/marketbeat/2010/10/27/pimcos-bill-gross-qe2-is-a-ponzi-scheme/ [10/27/10]
3 - bloomberg.com/news/2010-11-04/bernanke-doesn-t-understand-economics-investor-jim-rogers-tells-oxford.html [11/4/10]

Assessing the Mid-Term Elections

GOP picks up 60 seats in the House, 6 in the Senate. The 2010 midterm elections are over and frustration has prompted change on Capitol Hill. Republicans will control the House with at least 239 seats; Democrats will retain a narrow majority in the Senate with at least 51 seats.1

Here comes gridlock. “We’re determined to stop the agenda Americans have rejected and to turn the ship around,” Senate Minority Leader Mitch McConnell (R-KY) told the press after the election.2 So will President Obama’s health care reforms be rolled back? Will federal spending be severely reduced?

Through 2012, you may not see much change at all. With Republicans controlling the House, Democrats controlling the Senate and President Obama’s veto pen at the ready, you can expect plenty of legislative stalemates.

Could gridlock benefit the markets? It could be bullish for stocks. With a conservative majority in the House, Wall Street could breathe a collective sigh of relief over the next two years, feeling less regulatory pressure and seeing fewer threats and a more business-friendly environment.

On the other hand, history suggests otherwise. Standard & Poor’s database reveals that since 1900, the S&P 500 has gained an average of just 2.0% in years featuring a split Congress. Since World War II, the average gain in such circumstances has been 3.5%.3 Here’s hoping past performance is no indicator of future results.

What can the lame-duck Congress accomplish? Republicans don’t become the majority party in the House until January … so what will happen with the Bush-era tax cuts and the estate tax?

A compromise could be in the works on the estate tax. Neither party wants to see estate taxes reset to 2001 levels. With death taxes poised to top out at 55% next year, both parties may emerge from the limbo of 2010 and reach a consensus. A CNN report suggests the maximum estate tax rate will be set somewhere between 35-45% for 2011, with the federal exemption ranging anywhere from $3.5-$5 million.4

Both parties want to preserve the Bush-era income tax cuts. Analysts now think Congress may act to extend the EGTRRA/JGTRRA tax cuts through at least 2011.4 Will they be extended for all Americans, as Republicans want? Or just to households with incomes of less than $250,000, as Democrats want?

Two (lame duck) Democrats have proposed extending these tax cuts for all but the really rich. Senate Banking Chairman Chris Dodd (D-CT) would like them extended for households making less than $500,000; Sen. Blanche Lincoln (D-NE) has proposed setting the break at $1 million. In September, 31 House Democrats wrote a letter to their party’s leaders urging the extension of the cuts for all Americans.5

Other matters to tackle. Currently, the unemployed can qualify for up to 99 weeks of federal unemployment benefits. The Tier V unemployment extension is set to expire at the start of December, and if it does, about 2 million Americans will lose that cushion. Additionally, the Medicare reimbursement rate for doctors will be reduced by 21% if Congress doesn’t apply its usual annual “doc fix” by the end of November, and the Alternative Minimum Tax needs its annual patch.4

It is possible that one broad year-end tax bill could address all of the above issues.

What if the economy needs another stimulus? Given the mid-term election results, it is pretty clear that Federal Reserve will have to “ride to the rescue” instead of Congress. The GOP wants to block any new spending that adds to the federal deficit, so any initiative President Obama might propose to pump up the housing market or job market will likely be small-scale. It is hard to imagine another federal stimulus package making it through Congress between now and 2012, though a tax-cutting move might stand a chance.

Obama appeals to the business world. One last item of interest: in the wake of the “shellacking” his party took this week, President Obama spoke of mending fences with America’s business community. He now says he wants to undo Section 9006 of the health care reform law – the section that would require all businesses to issue 1099 tax forms notifying the IRS of purchases exceeding $600 starting in 2012.6

Citations
1 – latimes.com/news/politics/election/la-election-results-map,0,4890426.htmlstory [11/3/10]
2 – marketwatch.com/story/republicans-to-challenge-obama-after-victory-2010-11-03 [11/3/10]
3 – marketwatch.com/story/gridlock-is-no-good-for-stocks-2010-11-02 [11/2/10]
4 – money.cnn.com/2010/11/01/news/economy/lameduck_agenda/ [11/1/10]
5 - money.cnn.com/2010/10/13/news/economy/bush_tax_cuts_possible_compromise/index.htm [10/13/10]
6 - money.cnn.com/2010/11/03/news/economy/Obama_business/index.htm [11/3/10]

The Information Risk Premium: Danger and Opportunity

When you step back and look at the investment landscape, it is sometimes helpful to ask yourself if anything really IS different this time; to try to determine what has changed.

The usual answers point to recent return gyrations: the tech bubble's spectacular burst ten years ago, the near-death experience of global capitalism in 2008-2009. But the truth is, we've seen all this before in one form or another. Ask your grandparents; the 1929 crash and Great Depression were far more painful to far more people than anything we've experienced in recent years.

Michael Aronstein, who manages a mutual fund called the Marketfield Fund, offers an interestingly different take on what is fundamentally different today. In a one-hour speech at the NAPFA Practice Management & Investments Conference in San Diego on September 22, he connected two dots that most of us are aware of intuitively, but may not have consciously considered. He said that the primary challenge for investment advisors, financial planners and money managers today, which is different from the challenges you faced in the past, is the sheer amount of attention that individual investors are now able to pay to the ups and downs in their portfolios.

"In the last 15 years," he said, "we have moved from an era where people who were not in the business would check stock quotes, if at all, in the morning when they got their newspaper. Sometimes, you would listen to a radio program on your way home from work, and it might tell you what the Dow Jones Industrial Average closed at."

Compare that with today, when it's possible to have a running ticker at the bottom of your computer screen, or a portrait of your investment portfolio continuously updating its various components and arriving at new values every 15 minutes. At the same time, news, information and even fundamental analysis might be flowing into your brain through various sources. "Regarding the economy and its various indicators, there are probably ten thousand data points that we could be looking at in real time," Aronstein continued. "Combine that with hundreds and hundreds of opinions being thrown around as important every day, and it is a formula for driving everybody insane--and I think that really is what is happening to the investing public."

Put in its simplest terms, we are being driven to an unbalanced mental state by the sheer amount of information and opinions that are piling into our awareness at increasing speed, and nobody has a vested interest in telling us that paying attention is highly unlikely to improve our investing lives. In fact, to the extent that we feel panic, fear or a concern that we're missing out on some opportunity, all this information may well be sabotaging the average person's returns.

Panic is a particularly dangerous emotion to investment portfolios, and there is some evidence that more of it is being artificially manufactured by the media than ever before. Aronstein pointed out that it has become a pretty good business to give out doomsday information and frighten investors, and a lot of people have become pretty good at it. "It is rare to spend a day watching CNBC or any of the other financial reality programs," he said, "and not hear somebody come out with the most disastrous, frightening, extreme forecast about what is going on in the world and in peoples' portfolios."

That, in itself, helps us get a better handle on this new era of investing. Aronstein said that risk assets like stocks, which tend to be liquid and priced every second, become increasingly unattractive in an environment where there is a negative or confusing spin on their every movement. Who wants to own something which increasingly gives you heartburn and insomnia? As people sell out of the investments in order to avoid this confusion/heartburn factor, risk assets become more attractively priced than their fundamentals would justify. This could raise their future returns the same way value stocks enjoy return advantages over sexier growth companies: they are less attractive to the average investor.


Instead, investors might become more interested in investments which aren't traded every day--such as real estate and certain types of hedge funds. Because there is no way to watch them change in value in real time, the market commentators aren't talking about them or offering doomsday scenarios before the commercial break. Look for these products to proliferate, not necessarily because anybody believes less-liquid products offer better returns, but because they reduce stress.

It would be easy to say that market reality shows represent a scourge on the investing world. Of course they are unhelpful. Of course the moment-by-moment market movements and most of the data and opinions are of less than zero value to your financial health.

But the important thing here is for all of us to recognize that a new risk factor has emerged in the investment marketplace. This emerging "information risk premium" suggests that if you can tolerate (or ignore) the uncertainty and doomsday commentaries while others cannot, you might be able to get better returns for your ultimate retirement.

How Healthy is the US Dollar?

The strong dollar policy is long gone, but the greenback isn’t in peril just yet.

A favorite doomsday scenario. Have you heard about the forthcoming collapse of the dollar? Well, if you turn on your computer, your radio and even your TV, you just may. With the Federal Reserve poised to increase the money supply, the commentary on this topic is heating up again.

The scenario has variations, but the basic outline goes like this: An unexpected political or economic event leaves the dollar so weak that all confidence in it is gone. Foreign nations sell Treasuries in a panic and the Fed becomes the buyer of last resort. Traders and individual investors dump dollars for whatever they can get. Interest rates leap. Next stop: hyperinflation. America’s economy suddenly resembles that of Zimbabwe in 2007 or Germany in 1922.

So is there any validity to this scenario? Could the dollar collapse?

Let’s just say that the odds are very long. While the Federal Reserve will likely ramp up quantitative easing in the near future, it is highly unlikely that the dollar will suddenly become too cheap.

Why it is unlikely to happen. Foreign countries don’t want the dollar to collapse. Fundamentally, that is because some of the world’s biggest manufacturing economies rely on a great customer for their exports – the United States of America.

China and Japan currently hold 41% of America’s debt.1 In the worthless dollar scenario, they are the key dominoes that fall. But what incentive do China and Japan have to sell dollars? Their economies are tied to U.S. consumer spending. Selling dollars would not benefit them – it would drive up the prices of their exports to America, it would wreck the economy of their best customer, and it would harm their own economies in turn.

The dollar is also the world’s reserve currency; it has been so since the U.S. abandoned the gold standard during the Nixon administration. While the central banks of China and Russia have argued that it should be supplanted or replaced, no challenger has knocked it off its pedestal. In spring 2010, the International Monetary Fund concluded that the dollar still accounted for 61.5% of global foreign exchange reserves, with the euro coming in a very distant second at 27.2%.2

In a way, the dollar has “collapsed” – and America is still standing. The dollar is much weaker today than it was in the 1990s, or even in the early 2000s. Its value has gradually declined and may decline further despite recent surges. In mid-October, the U.S. Dollar Index had slipped about 7% since August, and was approaching an all-time low set back in April 2008.3

America’s debt was less than $3 trillion in 1990; it has doubled since, and the federal Office of Management and Budget thinks it will hit $15 trillion by 2015.1 The federal government would certainly rather pay those debts back using a declining dollar.

Of course, analysts also talked about the pound collapsing and the euro collapsing earlier this year. All this talk – and expectations about what the Fed will do – sent many investors toward the precious metals market, where gold and silver futures hit new highs.

A little word about diversification. When you hear commentators talking about the oncoming collapse of the dollar, take it with a grain of salt. This much is true so far: a dollar decline has occurred, and the dollar could weaken further. So it might be worthwhile to consider diversifying your portfolio as a cautionary move.

Citations
1 – azcentral.com/news/articles/2010/09/19/20100919debt-of-us-grows-with-debate.html [9/19/10]
2 – businessweek.com/news/2010-06-30/dollar-share-of-global-reserves-declines-imf-says.html [6/30/10]
3 – bloomberg.com/news/2010-10-19/geithner-weak-dollar-policy-seen-as-path-to-recovery-in-contest-with-brics.html [10/19/10]

Mid-Term Elections & Stocks

Historically, these events tend to help equities.

You may have heard that stocks tend to rally in fall and winter. That has often been the case. In fact, the S&P 500 and the Dow have gained repeatedly after the elections occurring in the third year of a first-term presidency.

These elections seem to elate Wall Street. While past performance is no indication of future success, consider this: Wall Street has witnessed rallies after every mid-term election since 1942.1

The Leuthold Group, a Minneapolis-based investment research firm, has determined that the S&P 500 has gained an average of 18.3% in the 200 days following such elections. Widening the window of time, Goldman Sachs finds that the S&P has averaged an 18.1% advance during the 12 months following each of the 15 mid-term elections since 1950. (The gain averages 11.0% when control of Congress changes hands.)1,2

Consider another intriguing statistic regarding mid-term election years: in the five instances since 1942 when an incumbent first-term president was a Democrat, the S&P 500 has gained an average of 21.3% for the year.3

The Dow may get a tailwind from the “third-year effect”. Since 1945, the third year of a presidential election cycle has tended to be very positive for the Dow. As MarketWatch columnist Mark Hulbert noted recently, the DJIA has averaged +24.7% in such 12-month periods (usually measured in fiscal years, i.e., 4Q-1Q-2Q-3Q) since the end of World War II. In fact, the Dow’s average returns in other fiscal years of a presidential term have been puny in comparison: +4.0% in year one, +1.9% in year two and +3.3% in year four.4

Last month, Standard & Poor’s chief investment strategist Sam Stovall told the Wall Street Journal that the DJIA has risen an average of 17.1% in calendar years following mid-term elections since 1945, with less than 10% of these years seeing selloffs.5

Will 2010 follow the historical pattern? Excellent question – after all, no one is clairvoyant. This year, stocks have not followed the longstanding trends. Stocks typically do badly in September, yet September 2010 actually turned the market around. When it comes to November, let’s hope history repeats.


These are the views of Peter Montoya Inc., not the named Representative nor Broker/Dealer, and should not be construed as investment advice. Neither the named Representative nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information. www.montoyaregistry.com www.petermontoya.com

Citations.
1 - kiplinger.com/columns/value/archive/how-elections-affect-the-stock-market.
html [10/12/10]
2 - foxbusiness.com/markets/2010/10/05/gridlock-looming-wall-street-
stands-gain/ [10/5/10]
3 - cnbc.com/id/38538007/Midterm_Elections_Produce_Pain_Then_Gain
_For_Stocks [9/27/10]
4 - marketwatch.com/story/mid-term-elections-impact-on-stocks-
2010-10-04 [10/4/10]
5 - online.wsj.com/article/
SB10001424052748704062804575510482714106168.html [9/25/10]

SPEND LESS NOW, LIVE IT UP LATER

A little “delayed gratification” may help you retire more comfortably.

Baby boomers are known for wanting more out of life – and for living life on their own terms. They also get a bad rap as a generation weaned on instant gratification – wanting it all now, wanting to have it both ways.

It is neither wise nor truthful to paint a generation with a broad brush. What we do know in 2010 is that more Americans than ever are poised to retire. In fact, 10,000 Americans will turn 65 each day during the next 18 years.1 Will their retirements match their expectations?

Are boomers in for a collective shock? Many boomers are used to affluence and expect creature comforts in retirement. Yet many may not understand how much money retirement will require. A 2010 study from the non-profit Employee Benefit Research Institute estimates that about half of “early” boomers (those aged 56-62) will face a retirement shortfall – someday, they will have inadequate income to pay medical costs and core retirement expenses. EBRI also estimates that 43.7% of “late” boomers (those aged 46-55) are likely to exhaust their retirement savings as well.2

Investing aside, what about the way we spend? EBRI research director Jack VanDerhei told TheStreet.com that beyond federal policy decisions, “[what is] even more important is to identify which of those households still have time to modify their behavior to achieve retirement security, and how they need to proceed." 2

What is a need and what is a luxury? Now here is where it gets interesting. In a new survey of more than 1,000 boomers conducted by MainStay Investments, more than half the respondents identified “pet care” and “an internet connection” and “shopping for birthdays and special occasions” as basic needs. Almost half checked off “weekend getaways” and “professional hair cutting/coloring” as basic needs. Perhaps the definition of a “basic need” is expanding. Or perhaps we have gotten so used to these perks that we can’t imagine living without them (and not spending money on them).3

Boomers are necessarily growing more pragmatic. The MainStay survey results hint at a shift in their financial outlook. The survey found that 76% of boomers were willing to work longer and save more in pursuit of more retirement comfort.3

Additionally, 40% of those surveyed said they will have to delay retirement in order to afford their desired lifestyle – and 47% said they would be willing to live in a smaller house to have more of the above luxuries/needs. A whopping 84% of respondents indicated they would be willing to allocate a portion of their assets so that they might have consistent lifelong income. However, just 52% of them were in contact with a financial consultant.3

We can learn from our elders. Look at the sacrifices made by the “greatest generation”. World War II demanded so much from Americans, not only in the theatres of combat but at home. For several years, new cars weren’t manufactured, travel was discouraged, and food, clothing and gasoline were rationed. The entire economy was rearranged, and more than 40 million Americans had to start paying federal income tax.4

This generation certainly understood delayed gratification. Yet with all that economic and political upheaval, its members collectively enjoyed the most comfortable retirement in American history (and perhaps the history of the world).

Will we pay for today’s lifestyle tomorrow? Financially, that is a risk we face. Many of us have not saved enough for retirement, and the financial markets have been especially volatile of late. So it only figures that spending less and saving more today could help us out tomorrow. Who knows - if some extra effort is put in now, we may end up with enough money to “live it up” later.

Citations
1 – sacbee.com/2010/08/29/2990176/baby-boomers-signal-shift-in-what.html [8/29/10]
2 - thestreet.com/story/10806795/even-wealthy-face-retirement-shortfall.html l7/15/10]
3 - freeerisa.com/news/fe_daily.aspx?StoryId={66D70228-CEFE-4782-9058-F2F2DAB68DD1} [8/5/10]
4 – nationalww2museum.org/education/for-students/america-goes-to-war.html [10/1/10]

The State of the Economy

The question on the mind of many investors has to be: where is the U.S. and world economy headed? Are we moving toward a double-dip recession, or is the economy in the early stages of a long-term recovery?

At a recent industry conference in San Diego, financial advisors heard a keynote presentation by economist Todd Buchholz, former White House director of economic policy and, before that, economics professor at Harvard University. His presentation was extremely candid, describing the 2008-2009 economic meltdown as "the most tumultuous economic times any of us have ever been through," later noting that it was a period when the Beardstown Ladies investment club outperformed the leading brokerage house investment divisions, when Mattel, the company that makes little hot wheels cars, has more market value than General Motors, which manufactures real ones.

But haven't we emerged from complex economic times in the past without this lingering uncertainty about where things are going? Buchholz said that if you aren't sure what's going on, you aren't alone. Economists are discovering that their economic models have grown increasingly out of touch with the realities of the marketplace. One big reason is that the world has changed dramatically. "When the Berlin Wall was pulled to the ground, millions of workers who had been trapped on the other side were suddenly free to compete against you, me, somebody writing software in San Diego or assembling textiles in North Carolina," Buchholz told the audience. "When you add in India and China, you have billions of new workers in the global workforce, which pushes down labor rates and inflationary forces here at home."

Today, the American worker is caught between two negative forces. It's hard to negotiate for higher wages when more than a billion workers are competing for his/her job. At the same time, newly-industrializing nations like India and China are clamoring for commodities, which raises the world price of everyday items like gasoline, cotton, cement, metals, food and whatever is made from those things.

So where do we stand today? Buchholz applauded the fact that the Federal Reserve Board has taken interest rates to zero and (as he put it) "stomped on the money supply accelerator." He doesn't expect this to lead to high inflation down the road because wages will be kept low by global competition for jobs, and because the new money is actually offsetting the 2008-2009 destruction of value in the real estate markets and the private sector. Unlike some economists, Buchholz believes the fact that housing inventories and home starts are going down is a good thing, because it means that home prices will be primed to rise again.

Jobs? Buchholz conceded that the job market is brutal right now, but he thinks this is normal at this stage of a downturn. "Whenever you have a recession, companies fire people and cut costs," he said. "When business picks up again, as it has in the U.S., they don't immediately call them back. Instead, they say, hey, Bill, can you stay an extra hour? Or: hey, Joe, come in a bit early tomorrow morning?" Recent rises in temporary worker hiring and overtime may be a precursor to hiring back full-time employees.

The bottom line? Buchholz doesn't expect to see a double-dip recession. "Consumers are showing more resilience and more composure than most professional economists anticipated," he said. "This is not a rip-roaring recovery, by any means. But earnings are better than expected, corporate cash on hand is greater than expected. Instead of a recovery that would grow the economy at 4-5% a year, we could see 2-3% growth for a while."

Is there a danger to this cautiously positive vision? Buchholz said that what worries him most is a backlash against capitalism in the U.S. Congress, which might impose trade barriers to protect U.S. industries. "There were three terrible policy mistakes that the government made which caused the Great Depression," he told the group. Two of them are unlikely to be repeated: the Federal Reserve allowed the money supply to collapse by 30%--the opposite of what the Fed is doing today--and Congress raised taxes dramatically across the board. But the third mistake was passing significant tariffs, triggering retaliation from other companies--and suddenly world trade fell by 40%. "I am very concerned today about trade tensions brewing around the world," said Buchholz, "even among friendly countries with the U.S."

At the end, Buchholz said that the most pressing issue, in his mind, is getting our educational system back into the global top tier. He said that increasingly, wealth is measured by the application of education and intelligence, and the world is catching up to the U.S. "Whoever harnesses intelligence most," he told the group, "will prosper most in the 21st century."

Darkness Before Dawn?

If you're feeling a bit gloomy about the economy and the markets, you have a lot of company these days. Despite U.S. stocks getting off to a positive start in the scary month of September, the news seems to be all about the possibility of a double-dip recession. One economist, David Rosenberg of Gluskin Sheff, has suggested that the recession never ended despite positive economic growth in the first half of 2010. Meanwhile, the put-call ratio, which compares the number of put and call options being bought and sold in the market, stands at an unusually bearish 1.28, according to the investment web site EquityClock.com. That means many more professional investors are betting against a market rise than for one.

All of this gloominess is leading investors to search for alternatives to corporate stocks--including gold and cash equivalents like CDs and Treasury bills. One online blog is titled "Nine Adult Entertainment Stocks to Weather the Recession;" it recommends Playboy and several providers of "mature entertainment" in hotel rooms.

There's only one problem with following the herd down this gloomy path, or stuffing your portfolio with gold and smut. In the past, people have been least optimistic about stocks and the economy right before the economy recovered and the markets produced higher-than-average returns. Business Week published its famous cover article entitled "The Death of Equities" in August of 1979, after the stock market had sustained serious losses and the long-term health of the U.S. economy was in doubt. The article noted a massive flight of investors from the market--right before one of the longest and most powerful bull runs the market has ever seen, which would take the S&P 500 index from just over 95 in 1979 to more than 1469 over the next 21 years.

And that gloomy put-call ratio? According to the investment encyclopedia Investopedia: "Many traders will consider a large ratio a sign of a buying opportunity."

If you want an extreme view of gloom and doom, then consider this quote from Time Magazine: "In a normal rebound, Americans would be witnessing a flurry of hiring, new investment and lending, and buoyant growth. But the U.S. economy remains almost comatose a full year and a half after the recession officially ended. Unemployment is still high; real wages are declining... The current slump already ranks as the longest period of sustained weakness since the Great Depression."

Sounds pretty awful, right? Except that this is a quote from Time's September 28, 1992 issue, talking about the gloomy prospects for the economy coming out of the 1990-91 recession. It reflected the mood of economists and the country at large--and, with the generous benefit of hindsight, we now know that this severe downer of an article was followed by a 16 year economic boom in the U.S. economy, without a single down year until 2008. The S&P 500 ended calendar 1992 at just over 435, and climbed, with more ups than downs, to just over 1576 at the peak in 2007.

There are good reasons to be cautious in today's economy and investment markets. We don't know what the markets are going to do tomorrow or next year. But the good news is that everybody else doesn't too.


Rosenberg on the idea that the recession never ended: http://www.businessinsider.com/never-ending-recession-2010-8

Death of Equities article: http://www.businessweek.com/investor/content/mar2009/pi20090310_263462_page_2.htm

Time magazine quote: http://www.time.com/time/magazine/article/0,9171,976602,00.html

S&P 500 data set: http://www.econstats.com/eqty/eqea_mi_1.htm

Equity Clock: http://www.equityclock.com/2010/09/12/stock-market-outlook-for-september-13-2010/

Investopedia: http://www.investopedia.com/ask/answers/06/putcallratio.asp

Developed and Overextended

Conventional wisdom says that buying Treasury bonds is the safest place to put your money, and very nearly as safe is putting your money into the sovereign (government-issued) debt of other developed nations like Japan, England, Germany, Spain and Greece.

But I'm sure the first thing that came to your mind when you saw that short list of developed nations was: wait a minute! Didn't Greek government bonds nearly default last Summer? Wasn't Spain on some kind of watch list? Isn't the U.S. deeply in hock to China? And, of course, you're right; there is growing evidence that, after bailing out their economies after living beyond their means for decades, developed nations around the world have overextended their balance sheets.

This has produced one of of those strange anomalies that you see in the investment markets from time to time: what may be the safest government bond investments around the world also happen to be some of the highest-yielding.

Much of this is laid out in a fascinating new white paper authored by Rob Arnott and Research Affiliates, Inc. in Newport Beach, CA. Entitled "Debt Be Not Proud," the paper compares the total percentage of government debt outstanding for developed and emerging nations with other measures that hint at these countries' ability to pay back what has been borrowed. The report tallied up the total debt that developed nations--Europe, Japan, the U.S., Canada, Australia etc. currently have on their books--$16.7 trillion in all--and calculated that this makes up 89.5% of the world's total. Yet these developed economies make up only 62.4% of the global economic output (what economists call GDP), and have just 19.1% of the world's population.

That's right; countries with just 19.1% of the world's population have borrowed almost 90% of the world's total sovereign debt.

The figures for the United States alone are not totally comforting, but by at least one measure, we are not out of line. The U.S. population represents 5.9% of the world's people, but our economy makes up 23.6% of the world's GDP. Our share of the total debt: 23.2%, slightly less than our share if measured in terms of economic output.

The situation is completely reversed for the smaller, less-developed countries, and yet they're paying MORE in interest to borrowers than the larger, less-solvent nations. In aggregate, the government debt of emerging markets is paying more than twice what U.S. Treasuries are offering. The International Business Times recently estimated that 10-year bonds issued by countries like Malaysia, India, Peru and Hungary are yielding an average of 6% a year, compared with 2.5% for U.S. Treasury bonds of comparable maturity. The article notes that many of these less developed countries are in better fiscal condition than the nations whose banks teetered on the edge of collapse during the credit crisis and recession.

This assessment is confirmed by the Research Affiliates white paper, which points out that total government debt issued by emerging market nations--just over $1.95 trillion--equals 10.5% of the world's total. Yet these economies include 80.9% of the world's population and their economies generate 37.6% of the world's economic output. The paper argues that their balance sheets are, by these measures at least, much stronger than the countries you normally associate with economic strength. Indeed, the report notes that China and Russia have foreign reserves larger than their respective bond debt, while Saudi Arabia, Kuwait, Qatar, the Cayman Islands, Monaco and Lichtenstein all have zero net debt. Of the 45 emerging markets that are included in various indexes, only Taiwan and Singapore have as much debt as ANY of the G-5 countries, measured relative to GDP--and by most measures, those two countries really belong on the developed side of the equation.

What does this mean for investors? Emerging market debt is probably yielding a bit more than the fundamentals would justify. But the real story may be just how overextended the developed world's balance sheets have become following the recent economic trauma. Greece and Spain may be the headlines today, but the industrial nations that don't successfully reign in their borrowing in the next ten years could become the subject of scary headlines somewhere down the road.


Research Affiliates white paper can be downloaded here: http://www.researchaffiliates.com/index.htm

Emerging markets debt vs. Treasuries: http://www.ibtimes.com/articles/62196/20100914/emerging-markets-bonds-yields.htm

OBAMA’S MIDTERM TAX PROPOSALS

The President recommends what amounts to a second stimulus package.

Many Americans are frustrated with the pace of the economic recovery; many Democrats are worried that their party will lose its majority in the House and Senate. As elections loom, President Obama has offered a new platform of tax initiatives for Congress to consider and potentially approve.

Extending the Bush-era tax cuts (for the middle class). President Obama wants to extend the EGTRRA and JGTRRA cuts of the last decade – but not to what Treasury Secretary Timothy Geithner referred to as the “most fortunate 2% of Americans.” Taxpayers who earn more than $250,000 would see those tax breaks disappear in 2011, while others would still benefit from them.1

Why not extend the Bush-era tax breaks for the demographic that is probably the most economically influential? “We don’t think that’s responsible economic policy,” Geithner commented during an interview on the FOX Business Network. He felt that preserving the cuts for the highest-earning Americans would be analogous to “borrowing hundreds of billions of dollars from our children.”1

Some contend that EGTRRA and JGTRRA have had broader impact. The Tax Foundation (a non-partisan Washington D.C. think tank which often criticizes tax policy) claims that the Bush-era tax cuts have saved the median U.S. family of four about $2,200 per year.2

However, an August Gallup poll indicated that only 37% of Americans wanted to keep the 2001 and 2003 tax cuts in place for all taxpayers. A plurality (44%) wanted to end them for those earning above $250,000, and 15% wanted them gone altogether. In partisan terms, 60% of the Democrats polled favored extending the cuts for all but the wealthiest Americans; 54% of Republicans polled wanted them retained for everyone.3

Offering tax breaks for capital spending and R&D. President Obama wants to allow businesses to write off 100% of their investment costs through 2011. He also wants to bring back the research tax credit for businesses – it would be expanded and made permanent.

What would a 100% expensing credit do for the business sector? On the right, Harvard economist Greg Mankiw calls it a “good idea” yet feels “the impact will be relatively modest.” In his view, this tax break amounts to “a zero-interest loan if [companies] invest in equipment. But with interest rates near zero anyway, the value of the loan is not that great.” On the left, UC Berkeley economist (and former Labor Secretary) Robert Reich thinks that “the economy needs two whopping corporate tax cuts right now as much as someone with a serious heart condition needs Botox. The reason businesses aren’t investing in new plant and equipment has nothing to do with the cost of capital. It’s because they don’t need the additional capacity.”4

Historically, the R&D tax credit has favored larger companies with long track records in research rather than smaller firms. Since 1981, Congress has allowed the R&D credit to sunset 13 times – it expired again at the end of last year. In the Obama proposal, the most popular R&D tax credit offered to businesses would rise to 17% from 14%. Many Silicon Valley firms and biomedical firms would love any break they can get – R&D credits in India, China and Brazil are all greater than in the U.S., and France's R&D tax credit is six times more generous than ours.5

Infrastructure projects to provide added stimulus. The President also wants to devote another $50 billion to infrastructure spending on roads, railroads and airports. The money would be used to repair 150,000 miles of highways and 4,000 miles of railways, among other uses.6 Some transportation industry analysts see it as merely a drop in the bucket – but also possibly a step toward the creation of a national infrastructural fund.

What might the effect be? Moody’s Analytics chief economist Mark Zandi thinks the proposed tax breaks would be “helpful but they're not going to jump start the economy, at least not in the next six to twelve months.” Interviewed by CNN, Zandi noted that “Investment spending has picked up very nicely, that's not the problem. The problem is a lack of hiring.”7

David Rosenberg, chief economist at investment bank Gluskin Sheff, is one voice more skeptical about the business tax breaks. He notes that “We already have business spending running at its fastest rate in three decades … how ridiculous is it for the government to be targeting tax relief to the one part of the economy that needs it the least?”7

Standard & Poor’s chief economist David Wyss feels that any new government stimulus is better than none, saying that “going cold turkey” in 2010 would severely damage growth.7 The debate on Capitol Hill over these tax initiatives will likely amplify as we head into fall.

Citations
1 – foxbusiness.com/markets/2010/09/09/treasury-secretary-geithner-urges-approval-economic-tax-package/ [9/9/10]
2 – boston.com/business/personalfinance/managingyourmoney/archives/2010/09/expiring_bush_t.html [9/10/10]
3 – theatlantic.com/business/archive/2010/09/59-of-americans-want-to-mess-with-bush-tax-cuts/62779/ [9/10/10]
4 – economix.blogs.nytimes.com/2010/09/07/reactions-to-obamas-business-tax-write-off-proposals/ [9/10/10]
5 – mercurynews.com/politics-government/ci_15990903 [9/5/10]
6 – newsweek.com/blogs/the-gaggle/2010/09/08/does-obama-s-infrastructure-proposal-have-the-right-priorities.html [9/8/10]
7 – money.cnn.com/2010/09/07/news/economy/obama_proposal_react/ [9/7/10]

The Three Factors of Fear

Suddenly, in the past few weeks, the markets have looked a lot scarier to a lot of nonprofessional investors. Why? The answer probably has something to do with human psychology.

An Australian company called FinaMetrica has been giving lay consumers a scientifically-designed risk profile questionnaire for the past 12 years, helping financial advisors evaluate whether their clients are natural risk-takers or the kind of people who feel more comfortable if their money is stuffed safely in their mattress. A closer look at the responses, including 2,586 individuals who took the test before and after the recent bear market, shows something surprising: people were no more risk-averse after they had been clawed by the worst bear market since the Great Depression than they had been before.

Chances are, you're less excited about taking market risk now than you were in, say, the early months of 2007, so these results seem impossible. But the FinaMetrica people offer a plausible explanation for their results. They say that there are three components to your willingness to expose yourself to the ups and downs of the market. Two of them changed after the market downturn, and one of those two has recently changed again.

The first component is what might be broadly called your bravery; your willingness to take chances. This is the part that FinaMetrica measures directly, and its results show that if you were willing to skydive or take ski jumping lessons off the 90-foot hill before the Fall of 2008, you're just as excited by the idea of putting your life at risk now. The markets don't change who you are fundamentally.

The second component is your risk capacity; that is, how much financial risk you can afford to take. The 2008-2009 bear market might have caused a lot of us to rethink how early we might be able to retire, but a reprise of it might make us wonder if we can retire at all. So we become a bit more conservative in our investment approach.

Component number three is our risk perception. If we're watching the markets go up and up and up, then we see little risk and lots of upside. This is why, during the late 1990s tech boom, even the most timid individuals were throwing money into the market like drunken sailors. When the markets deliver the opposite experience, we look at stocks and see nothing but risk.

This last piece of the risk tolerance puzzle is, today, sending out alarm bells that may be echoing deep in your own psyche. The markets have just delivered the worst market performance in the month of August since 2001--which professional investors know is a random event. But now we're in September, that very same month when Lehman Brothers went down and AIG effectively declared bankruptcy back in 2008. It also happens to be the same month that the country experienced the shock of 9/11--which, among a lot of other things, sent the global investment markets reeling. Chances are you don't remember it personally, but September is also the month when the 1929 crash occurred.

So we had a dismal August that gave back the gains that the market had created in the first seven months of the year, and we're entering that scary month that we associate with recent financial disaster. Chances are, your logical mind knows that a reprise of 2008 is unlikely, and if you've been reading the papers, you know that corporate profits have been going through the roof in the American economy. But the emotional part of your mind looks at the market and conjures up every negative statistic, and sees far more potential risk than reward, and experiences fear even as you strap on your parachute at 15,000 feet and give an enthusiastic high-five to the instructor who is looking a little nervous.

We don't know whether the month of September will bring the markets back into positive territory or not, despite a lot of long-term analysis. But if you invest based on what the markets did recently, where does that lead you? August was negative, so get out in September. September is positive, so get back in. October is down; get back out; November is up, so you get back in--and over time, whether you follow this formula for months or years, or through bear and bull markets, you end up in the market when you would have preferred to be out, and out when it was better to be in.

As professionals, we try not to let greed OR fear dictate our portfolio composition. In the long run, that gives you an edge on others who are responding without understanding what, exactly, is driving them to the sidelines whenever stocks go on sale.

Overwork and Underspend

People in other countries think we Americans are a little weird in our work habits, and they may be right. The web site Expedia.com has recently conducted its ninth annual survey of international vacations, telling us how many vacation days are taken by workers of different countries. French workers get the most--38 days a year, on average, although they typically only take 36 of them. Italians receive 31 days, although, on average, they leave 6 of them on the table.
Americans? The web site reports that "throughout the eight years that the Vacation Deprivation survey has been conducted, the U.S. has long-held the dismaying distinction of being the country with the worst vacationing habits." Our workers, on average, receive 13 days of vacation time, less than any country in the developed world, including Japan (15), Australia and Canada (19 apiece), Germany (27) and Britain (26). Even so, more than a third of Americans don't take their full yearly allotment of vacation days; in 2009, the Expedia study found, we give back a total of 436 million of them.
To make matters worse, there is plenty of evidence, on the beaches, in restaurants and theme parks, that many workers are still slipping in an hour or two of productive labor on their days off, calling the office on their cell phones or earnestly consulting their blackberries. Expedia says that 24% of employed American adults do this, but this may be an undercount.
Meanwhile, 37% of employed American adults report regularly working more than 40 hours a week.
This compulsive work ethic may help explain another phenomenon that American financial planners frequently talk about at conferences: how difficult it is for some of their clients to spend their hard-earned money once they've accumulated more than they're ever likely to need.
It's not hard to find advice online and elsewhere for people who overspend and can't stay on a budget, but there seems to be no support or therapy available for a sizable number of Americans who long ago got in the habit of accumulating, and even when they've achieved the point where they no longer have to work, they still do, meanwhile living not beyond their means, but significantly--sometimes uncomfortably--under it. For some of us, stopping to enjoy what we've accumulated seems to be as hard as fully disconnecting from the office.
Is this really a problem? If your goal in life is to increase America's GDP and raise our average worker productivity statistics, then no, everything is fine. But one of the most poignant statements ever made at a financial services conference was offered by a rabbi who was asked to travel to Oklahoma City to offer grief counsel to the families of the victims of the bombing incident.
"In my line of work, I regularly sit with people in their last hour of life," he said, "and often people will tell me, with the benefit of hindsight, looking over the course of their lives, that they wish they had spent more time with their loved ones or children, or doing things that gave them pleasure. Never once, in all my years," he added, "has anybody expressed regret that they didn't spend more time at the office."

Link to the Expedia article: http://www.expedia.com/daily/promos/vacations/vacation_deprivation/default.asp .

Boringly Powerful

In the financial planning world, we're all trying to get better at what we do, and so whenever we get together at conferences, we trade thoughts and ideas and insights.
One of the most informative stories you're likely to hear came from an advisor who told the audience that he hosts yearly client appreciation dinners. Lately, he's been grouping the guests according to how long they've worked with him. At one table, those who've retained his services for the past five years. Another, people he's been advising for ten years. There's a 15-year table, 20 years, 25 and, at the table in front, people who he's worked with for 30 years.
"As I looked over at the 30-year table," he said, "I saw people who, when we first started out, were not wealthy and never expected to be." Now they're worth millions and (more importantly) able to live their life on their own terms.
One woman in particular caught his eye, a school teacher who had come to him in the first year of her teaching career. She had gotten into the not-unusual habit of spending a little more than she made. She was in debt, and one of the first things they talked about was whether she could afford an expensive car that she'd talked to the local dealer about.
The advisor's advice, which she took, was to buy a much more affordable, serviceable vehicle. He worked with her to pay off the credit cards, and over the rest of her teaching career, he encouraged her put the maximum into her 403(b) plan and save ten percent of her income and managed her growing retirement portfolio. The change in lifestyle was not dramatic, but it had a huge impact on her life: the year of this particular dinner, she had accumulated enough that she could afford to retire and travel the world.
"What's interesting," the advisor told the audience, "is that when she told the other teachers that she was going to quit work, their first question was: how can you afford it? The other teachers," he continued, "were still in the habit of spending a little more than they made, living year-to-year, and couldn't afford to retire."
Looking at this one person at the 30-year table, sitting among other people with stories like hers, he was struck by the huge difference a small course correction and a little financial coaching can have on somebody's life over longer periods of time: the difference between squeaking by financially and retiring with millions.
His first insight (which made the audience laugh) was: "I don't charge nearly enough for my services."
His second was: even though he worked hard to manage the portfolio efficiently, her rate of return was just about equal to what the market offered. That, in itself, is surprisingly extraordinary; according to data compiled by the Morningstar fund tracking organization, mutual fund investors, on average seem to get about half of market returns--because people tend to buy hot funds right before they cool off, and sell out of underperforming funds right before they hit a hot streak. By staying consistent with the schoolteacher's investments, the advisor added far more value than you'll likely find in any kind of fancy investment strategy.
But the real point--the most important insight--is that the difference between a table full of millionaires and their peers who spent thirty years spinning their wheels is a boringly powerful formula: consistent savings habits, avoiding debt, and living within their means in a world that constantly tempts us to overspend. When you reduce all the spreadsheet analyses, forecasts and formulas down to their purest essence, this is what most financial planners are trying to help people achieve in their lives. For the people at some of those 20-30 year tables, the real challenge now is how to use their excess money to have fun, and who they want to leave the excess to at the end of their lives.

Morningstar evaluations: http://news.morningstar.com/articlenet/article.aspx?id=340334 ; http://www.morningstaradvisor.com/articles/article.asp?docId=18710

Which Financial Documents Should You Keep on File?

What should you store in one easily accessible place?

You might be surprised how many people have financial documents scattered all over the house – on the kitchen table, underneath old newspapers, in the hall closet, in the basement. If this describes your financial “filing system”, you may have a tough time keeping tabs on your financial life.

Organization will help you, your advisors ... and even your heirs. If you’ve got a meeting scheduled with an accountant, financial consultant, mortgage lender or insurance agent, spare yourself a last-minute scavenger hunt. Take an hour or two to put things in good order. If nothing else, do it for your heirs. When you pass, they will be contending with emotions and won’t want to search through your house for this or that piece of paper.

One large file cabinet may suffice. You might prefer a few storage boxes, or stackable units sold at your local big-box retailer. Whatever you choose, here is what should go inside:

Investment statements. Organize them by type: IRA statements, 401(k) statements, mutual fund statements. The annual statements are the ones that really matter; you may decide to forego filing the quarterlies or monthlies.

When it comes to your IRA or 401(k), is it wise to retain your Form 8606s (which report nondeductible contributions to traditional IRAs), your Form 5498s (the “Fair Market Value Information” statements that your IRA custodian sends you each May), and your Form 1099-Rs (which report IRA income distributions).1

In addition, you will want to retain any record of your original investment in a fund or a stock. (This will help you determine capital gains or losses. Your annual statement will show you the dividend or capital gains distribution.)

Bank statements. If you have any fear of being audited, keep the last three years worth of them on file. You may question whether the paper trail has to be that long, but under certain circumstances (lawsuit, divorce, past debts) it may be wise to keep more than three years of statemetns on file.

Credit card statements. These are less necessary to have around than many people think, but you might want to keep any statements detailing tax-related purchases for up to seven years.

Mortgage documents, mortgage statements and HELOC statements. As a rule, keep mortgage statements for the ownership period of the property plus seven years. As for your mortgage documents, you may wish to keep them for the ownership period of the property plus ten years (though your county recorder’s office likely has copies).

Your annual Social Security benefits statement. Keep the most recent one, as it shows your earnings record from the day you started working. Please note, however: if you see an error, you will want to have your W-2 or tax return for the particular year on hand to help Social Security correct it.2

Federal and state tax returns. The IRS wants you to hang onto your returns until the period of limitations runs out – that is, the time frame in which you can claim a credit or refund. The standard IRS audit looks at your past three years of federal tax records. So you need to keep three years of federal (and state) tax records on hand, and up to seven years to be really safe. Tax records pertaining to real property or “real assets” should be kept for as long as you own the asset (and for at least seven years after you sell, exchange or liquidate it).3

Payroll statements. What if you own a business or are self-employed? Retain your payroll statements for seven years or longer, just in case the IRS comes knocking.

Employee benefits statements. Does your company issue these to you annually or quarterly? Keep at least the most recent year-end statement on file.
Insurances. Life, disability, health, auto, home … you want the policies on file, and you want policy information on hand for the life of the policy plus three years.

Medical records and health insurance. The consensus says you should keep these documents around for five years after the surgery or the end of treatment. If you think you can claim medical expenses on your federal return, keep them for seven years.

Warranties. You only need them until they expire. When they expire, toss them.

Utility bills. Do you need to keep these around for more than a month? No, you really don’t. Check last month’s statement against this month’s, then get rid of last month’s bill.

If this seems like too much paper to file, buy a sheet-fed scanner. If you want to get really sophisticated, you can buy one of these and use it to put financial records on your computer. You might want to have the hard copies on file just in case your hard drive and/or your flash drive go awry.

Citations
1 - kiplinger.com/columns/ask/archive/2004/q0206.htm [2/6/04]
2 - ssa.gov/mystatement/currentstatement.pdf [1/10]
3 - irs.gov/businesses/small/article/0,,id=98513,00.html [4/8/08]

WILL THINGS IMPROVE FOR MEDICARE AND SOCIAL SECURITY?

The healthcare reforms may lead to some short-term aid.

Could Medicare soon be in better shape? Maybe. At the start of August, Medicare’s trustees reported to Congress that Medicare should remain financially in the black through 2029, a 12-year improvement over last year’s estimate.1 They credited the healthcare reforms carried out by Congress and the Obama administration, citing greater efficiency that would translate to savings for the program.

However, there is no guarantee that Medicare will get to retain those federal savings, and no certainty that the savings projected by eliminating subsidies paid to private insurers will result.

Additionally, as Concord Coalition executive director Robert Bixby told the Los Angeles Times, “You can’t spend the same money twice.”2 It would seem unwise to use Medicare savings to expand Medicare coverage.

The Medicare trustees claimed that with the projected $192 billion in cuts to Medicare Advantage plans, home health care and hospitals across the next ten years, both the 75-year shortfall for its hospital fund and projected costs of the Medicare Supplementary Insurance program will shrink. More alterations will be needed to keep Medicare running in decades to come, the August report notes.1,3

Social Security’s fortunes could be enhanced in 2019. Why 2019? In that year, a new tax is scheduled to kick in for so-called “Cadillac plans” – health insurance packages with annual premiums of $8,000 or more for individuals or $21,000 or more for families. In 2019, insurers offering these plans will have to pay a 40% federal tax for every dollar spent over the $8,000 or $21,000 cutoff.1,4

That tax is projected to give Social Security a bit of relief. In 2010, Social Security is paying out more than it is taking in – and by previous federal estimates, that wasn’t supposed to happen until 2016. According to government forecasts, it can continue using payroll taxes and interest income to cover benefits until 2024.1

The projection that Social Security’s accumulated surplus will run dry in 2037 is unchanged. After 2037 (assuming things don’t change), Social Security’s program revenues would only cover about 75% of its expenses – so payroll taxes would have to increase, or benefits would have to be scaled down.1

Until both programs receive true long-term fixes, we will all have to make do with these short-term encouragements.

Citations
1 - nytimes.com/2010/08/06/health/policy/06medicare.html [8/5/10]
2 - latimes.com/news/nationworld/nation/wire/sc-dc-0806-social-security-20100805,0,6306255.story [8/5/10]
3 - csmonitor.com/USA/Politics/2010/0322/Health-care-reform-bill-101-What-does-it-mean-for-seniors [3/22/10]
4 - slate.com/id/2232434 [10/14/09]

Thinking About Investing

Have you ever felt anxious about your investment portfolio? Who hasn't? A recent presentation at one of our professional conferences pointed out that five out of every six years will produce a stock market return sequence that either triggers anxiety or smacks your portfolio so hard that you wonder why you ever trusted the markets to begin with.

This is normal. Many people simply cannot handle stock market volatility, which is why the people who DO have, historically, tended to make more, over multiple ups and downs, than the people who kept all their money stashed away in Treasury bonds.

The question is: is there better way to handle the inevitable anxiety that comes with buying stocks?

Psychologist Ken Haman, who now works at the investment firm AllianceBernstein, says that the key is to stay rational. He points to studies of the human brain which shows that all of us actually have two brains. One is the neocortex, where all of your higher thought processes take place. Below the neocortex is a primitive brain which is about as smart as an alligator, and this lower brain happens to be where all of our survival instincts are housed. Whenever you experience panic, the primitive brain immediately takes over and shuts down the neocortex--which allows you to respond instantly (rather than thoughtfully) on those many occasions when a saber-toothed tiger is running in your direction.

So when the markets have spent the past quarter giving up all the gains they generated in the first quarter, what do you do? First, talk with somebody who actually listens to you about how you're feeling. Then start to engage your neocortex. What do you imagine is going to happen in the future? Then move to: is that what you think, or how it feels?

When your neocortex is functioning again, you can look at some of the past market declines and see what happened next, or look at your financial situation and take stock of your progress toward your financial goals.

People who can handle the stock market roller coaster without getting sick seem to have an unfair advantage over everybody else in the investment world. It seems to depend on which part of your brain is in control.

WILL THE BUSH-ERA TAX CUTS BE SAVED?

What might happen if they went away? The debate is gaining volume.

In July, Treasury Secretary Timothy Geithner said that very few taxpayers would be affected if the landmark tax cuts of 2001 and 2003 expired. “I do not believe it will affect growth,” he calmly commented on ABC’s This Week.1 Many legislators and observers on Wall Street and Main Street are far less calm about their potential end.

Why should they end now? The federal government undeniably needs more revenue to help shrink the deficit, and Geithner feels that letting these tax cuts go would not trigger a double-dip recession, as they affect only 2-3% of U.S. taxpayers.1 However, many Republicans and more than a few Democrats see danger here as the richest Americans are also the most influential in job creation.

Deutsche Bank says “don’t do it”. Analysts at the banking titan recently offered their opinion: letting the Bush tax cuts expire would exert a drag of anywhere from 1.1% to 1.5% on U.S. GDP.2 The analysts warn that letting the tax cuts sunset as the federal stimulus winds down could create an economic scenario in the U.S. akin to the one Japan experienced back in the 1990s.

Grassroots momentum gathering. A new website created by the conservative League of American Voters (ReviewTheTaxCuts.com) is gathering signatures in conjunction with a TV ad campaign starring ex-presidential candidate Fred Thompson. This effort comes on the heels of Rasmussen and Gallup polls showing increased concern about taxes. In a mid-July Rasmussen Reports poll, 68% of Americans surveyed said taxes had become a “very important” issue. In April, 63% of Americans surveyed by Gallup felt their taxes would rise in 2011, the largest percentage to respond this way since 1977.3

A battle this fall in Washington. Republicans on Capitol Hill ardently want the tax breaks to remain in place. Democratic leaders in the Senate are striving to introduce a bill in September that would seek to preserve the cuts for the middle class only. Most Democrats seem to favor letting the tax cuts expire for households earning more than $250,000. House Speaker Nancy Pelosi (D-CA) is among the voices contending that they didn’t aid the economy much in the first place. Closer to the White House, Secretary Geithner feels that letting the cuts expire would send a message to the world that America is serious about tackling its deficit.3

This is an election year for many members of Congress, and it wouldn’t be surprising if some seats changed hands as a result of the influence of this issue.

More voices. Former Federal Reserve vice-chairman Alan Blinder favors letting the cuts expire. “We couldn't afford them then (and knew it), and we can't afford them now (and know it),” he recently told the Washington Post. “What might be the argument for retaining the tax cuts even though the long-run budget is deeply in the red? That America needs more income inequality? Seems to me we have enough.”4

MoodysEconomy.com chief economist Mark Zandi calls for moderation. Zandi feels the 2001 and 2003 cuts “should be extended permanently for families with annual incomes of less than $250,000 and should be phased out slowly for those making more than that.”4

If the sun sets on these cuts, taxes revert to pre-2001 levels. EGTRRA gave us six tax brackets (10%, 15%, 25%, 28%, 33% and 35%). If EGTRRA went away, so would the 10% tax bracket (the lowest bracket would become 15%) and the 25%, 28%, 33% and 35% rates would be respectively bumped up to 28%, 31%, 36% and 39.6%. (Households earning more than $379,650 would pay taxes at the 39.6% rate.)5

Then we have capital gains, of course. The ceiling on capital gains tax rates would move back up to 20% if these cuts expired. Additionally, qualified dividends would again be taxed at a taxpayer’s regular rate … which could be as high as 39.6% (see above).5

The death of EGTRRA would also wipe out the child tax credit, restore the “marriage penalty” (married joint filers wouldn’t be able to take 2x the standard deduction allowed for single filers) and bring back the phase-out for the personal exemption and itemized deductions.

There is much to consider. This will, most likely, become one of the hottest issues on Capitol Hill and across the country as we get closer to November.5


Citations
1 – nytimes.com/2010/07/26/us/politics/26geithner.html [7/26/10]
2 – cnbc.com/id/38467149 [7/29/10]
3 – blogs.wsj.com/washwire/2010/07/27/tax-cut-debate-grows-louder/[7/27/10]
4 – washingtonpost.com/wp-dyn/content/article/2010/07/30/AR2010073004758.html [7/30/10]
5 - forbes.com/2010/07/22/expiring-bush-cuts-affect-personal-finance-taxes.html [7/22/10]