Despite signs that a deal between Democrats and Republicans may be on the cards, tax cuts passed a few years ago may still be about to be reversed. The uncertainty is debilitating investors and firms, and for good reason. The top rate of federal income tax would go up from 35 per cent to 39.6 per cent on New Years’ Day; this wouldn’t raise much but would hit the decision-makers who will determine whether or not the US bounces back next year. There would also be tax hikes lower down the income scale.
The plan is also for a one third increase (from 15 per cent to 20 per cent) in the top capital gains tax rate; the top federal estate tax rate would jump from 0 per cent to 55 per cent; and the top dividend tax would jump from 15 per cent to 39.6 per cent, an increase of 164 per cent (the tax is slated to rise again to 43.4 per cent by 2013).
All of this would be a disaster for investors and entrepreneurs (and hence job-creation): higher capital gains taxes would slash post-tax returns, cutting expected gains from the stock market, the creation of new firms and other investments. This would reduce the demand for equities and discourage the creation of new companies. An increase in the tax on dividends would also depress the value of US equities: shares are valued as the discounted net present value of future cash flows, namely dividends and share buy-backs, both of which will be cut post-tax. Thus expect the stock market to take a hit.
America faces a crippling budget deficit and an exploding national debt; unless it acts, it too will end up facing a sovereign debt catastrophe. Yet even if all the tax cuts were extended, revenues would gradually recover over the next couple of years to exceed their historical average of 18 per cent of GDP. But federal expenditure is predicted to jump from its historical average of 20 per cent of GDP to 26 per cent by the end of this decade. The government is suffering from a temporary revenue problem – but a long-term, structural over-spending problem caused primarily by middle-class entitlements. It should tackle the latter, not the former.
The Heritage Foundation has used the IHS Global Insight model to work out what would happen if taxes were hiked next month. GDP would grow at a much slower rate; the US economy would be $145bn smaller than it would otherwise be by 2018. Around 693,000 fewer jobs would be created.
To this should be added the fact that the extreme uncertainty facing US investors and firms right now is preventing a real recovery. It is not just the possibility of huge tax hikes. As Donald J Boudreaux of George Mason University points out, the hyper-frantic Fed, fears about the dollar and anxiety over what Obamacare and Dodd-Frank will actually mean are all contributing to the malaise.
Unless America finds the courage to tackle its out of control entitlements culture and increasingly bloated and wasteful government, it too will condemn itself to a future of ever higher taxes, weaker growth and generalised decline. Investors have been warned.