Will the Economy Collapse In 2011?
| June 11, 2010 | Posted by Roshawn Watson under Uncategorized |
By: Roshawn Watson
People can change the volume, timing, and the location of their income in response to changes in tax policy. Next year, the highest federal personal income tax rate will go from 35% to 39.6% , the highest federal dividend tax rate increases from 15% to 39.6%, the capital gains tax rate increases from 15% to 20%, and the estate tax rate increases from 45% (in 2009) to 55%. With the steep increases in federal, state, and local taxes scheduled for next year, will economic activity be stifled to the point of economic collapse in 2011?
The Laffer Curve
Economist Art Laffer, creator of the Laffer Curve certainly thinks so, and he has provided some compelling arguments.
When we pass the tax boundary of Jan. 1, 2011, my best guess is that the train goes off the tracks and we get our worst nightmare of a severe “double dip” recession.
His basic premise is that there is a point where increased taxation no longer results in a corresponding increased revenue for the government: there is a sweet spot with respect to taxation. Maryland certainly felt the impact of over-taxing its residents when lawmakers enacted a special millionaire tax to cover budgetary deficits. The profound result was millionaires paid over a $100 million less in taxes compared to year prior to the enacting the tax, even though the tax rate was higher. Maryland literally lost one-third of its millionaires in a single year, and most believe it is partly attributed to enacting the millionaire tax. From those missing millionaires, Maryland collected nothing. Simply put, you just cannot tax people beyond their willingness to pay. The classic example is if you were taxed at a rate of 120% of your income, how long would you work?
Impact of Anticipating Higher Taxes on Economic Activity
Anticipation of higher taxes will motivate people to shift income and production from next year to this year. Consider billionaire Eddie Lampert. According to Bloomberg & Business week, his hedge fund distributed him $829 million in stock this year, so far. The fund is scheduled to transfer more shares to Lampert by the end of July. Because he is taking the stock now, he will be taxed at the current capital gains rate of 15% when he decides to sell. However, if he were to wait until next year, under proposed legislation in Senate, he would pay the higher ordinary-income tax rate of 39.6%. Robert Willens owns a New York firm that specializes in reducing tax burden of its Wall Street clients. Willens commented that Lampert’s decision to take a stock distribution is totally astute and “(i)t doesn’t take a fortune teller to predict that we are going to see a lot of this activity between now and the end of the year.” In addition to retaining the capital gains treatment of the stock, Lampert still controls the timing of the sell, so he can determine to sell during a year that minimizes his taxes. Frank McCourt, owner of the LA Dodgers, illustrates how timing such a transaction can dramatically reduce one’s tax burden. He recently received $108 million in income and paid no federal and state taxes because of loss-carry forwards.
Laffer further argues that this pattern of shifting economic activity based on tax policy occurs repeatedly and can have a profound impact on the economy. A poignant example occurred in the early 1980s. The majority of Reagan’s tax cuts didn’t go into effect until 1983, and people consequently delayed economic activity in 1981 and 1982 to the point where the real GDP was flat (no growth) while the unemployment rate rose to 10%. However, the pent-up economic activity took off in 1983 , as growth increased to 7.5% and further increased by 5.5% the following year. Accordingly, the impact of the deferred tax increases for next year may be in reverse, and Laffer predicts the economy will collapse in 2011.
This is the product of removing incentives for production through increased taxation.
The fact that corporate profits as a share of GDP are already too high given the state of the U.S. economy reflects the shift in income into 2010 from 2011. “These profits will tumble in 2011, preceded most likely by the stock market” according to Laffer.
Regardless of your views about a potential double dip recession, some feel all of this complaining about taxes is going too far. After all, aren’t we just raising income taxes back to pre-Bush levels? Consider that a chief justice once said that a citizen has not only the right but a duty to pay only the minimum tax applicable to him. It sounds like even chief justices aren’t so keen on paying taxes either. The point is taxes are not a trivial thing. Taxes typically represent our single largest lifetime expense: we’re taxed when we earn, spend, save, invest, and die. It’s naive to think that changing tax policy doesn’t affect consumer and business behavior. Indeed, the nine states without an income tax are growing far faster and attracting more people than are the nine states with the highest income tax rates. This is simply a fact.
Laffer Is Not Infallible
Art Laffer is certainly not infallible (after all, who is?). Recall four years ago, he argued with Peter Schiff about the the probability of whether we would enter a recession in 2007 or 2008. His words were “the economy has never been in better shape (watch it for yourself).” Of course, this prediction was inaccurate, and he subsequently admitted so.
[youtube=http://www.youtube.com/watch?v=IU6PamCQ6zw]
Of course, Laffer isn’t the only prominent economist fearing a double dip recession. Nouriel Roubini argues that the U.S. recovery is far from a sure thing yet. He believes the recovery has a 60% chance of being slow and anemic with little growth for the next two years; however, his modeling also suggests that there is a 20% chance that we will have a double-dip recession. Side note, Dr. Roubini did correctly predict that the US would enter a recession in 2006, just as Schiff.
It’s Your Economy That Matters
With $13 trillion in debt, our economy certainly has seen better days. Better unemployment news helps, but there are some tangible challenges we face. Regardless of whether we are heading towards a double-dip recession next year, as I said in May 2008, what’s most important to you is your economy. “Will your finances be screwed up next year?” is a much more relevant question to you than whether or not we will have another recession. If you have a stable income there is no time like the present to get your finances in order. Consider discussing with your accountant the implications these changes to the tax laws will have on you. Perhaps, this may be the time to take a capital gain, or convert a traditional IRA or a 401K to a Roth IRA for tax free growth if you can afford to pay the taxes this year. For 2010, the prepayment penalties are waived. My wife’s first response to Laffer’s predictions was “how can we prepare?” What’s your first response?
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Copyright 2012, Roshawn Watson, Pharm.D., Ph.D. All Rights Reserved.
Great information Shawn. Laffer has definitely had a mixed record, but the effects of rising taxes are undeniable. No one knows for sure how the markets and economy will play out over the next few years, but your advice on taking care of your own finances is right on the money. Paying down debt and increasing savings are always a good strategy no matter what the economy does.
@BalanceJunkie,I do think the effects of increased taxes are clear, even though some continue to try to dispute them. With regard to paying down debt, saving for short-term expenses & emergency funds, & long-term investing. Those are pretty safe bets regardless of what the economy is doing.
The question of how much government we want and how much private sector we want is vitally important and should be explicitly debated at the national level.However it would come out I would just like to see us pay for what we want. Unfortunately it is too easy to make promises and then finance those promises by borrowing and running up the national debt. In the long run this also is a tax – one that erodes the value of savings.Recommendation to get personal finances in order is well made.
What an interesting comment. I agree such issues certainly need to be debated. Personally, I am not comfortable with this level of government intervention and do not care for the promises of government provision. God and I take care of me, not Washington. As you are suggesting, these promises tend to be unfunded liabilities, which ultimately get passed on to the American taxpayer. I also thought your comment on increasing the American debt is essentially robbing us is extremely astute although I would expect nothing less from you. I have never quite thought of it that way, but that's what inflation is. Inflation is the third biggest expense on the American people. Getting your own financial picture correct is pretty safe regardless of what the economy is doing. If we as a country were collectively more responsible, we wouldn't allow so much government intervention into private financial matters 1) it wouldn't be as necessary and 2) our ethos probably wouldn't allow it. Thus, we wouldn't tolerate this type of government intervention.
Yo Roshawn, tuff to say with the taxes. It is PAINFUL!May I ask you whether the tax increase will go into law on day one 2011? They have to pass the increase this year right?If you had an oportunity to join a start up firm, but they paid you a two year guaranteed raise increase (not one year), would you go?
Hey, Roshawn. Absolutely wonderful thought provoking post! In the midst of trying to develop a strategy for wealth building, you've inspired us to divert some of our attention to the tax situation as it can definitely have an impact on our financial well being. That's for keeping us on our toes.
@Financial SamuraiMy understanding is that the measure is in the Senate and has already passed the House. If Congress does not maintain the 2003tax cuts and simultaneously increases our taxes, this starts with income earned on (or after) 1/1/2011. I'm definitely not a tax professional though.I would consider the start up offer seriously; however, it would definitely depend on 1) location 2)opportunities for my wife 3)how such a job would impact my overall career. I do love a challenge though
@Financial Dream Where you been????Heck yeah with your "thought-provoking" accolade… Your comment highlights exactly what my purpose was in writing this post. Taxes must be a part of the plan. I don't like reading about the tax code, and few do. However, if you don't understand how it impacts you, even on a basic level, you risk completely screwing up your financial plan. That's unacceptable.
Excellent post. I for one am in the camp of thinking there is a higher possibility of a double dip recession than many believe. There are a lot of people still out of work, and people have seen their savings take a hit. Why should they spend? I'll be looking to trim costs, that's for sure. Then again, I'm a sample of one and a PF blogger, so I'm not entirely representative!
@SquirrelersI believe a double dip is certainly possible as well although I am hopeful that we will have a slower recovery instead. Unemployment is a major issue, and I don't think it takes much to send workers over the financial edge, with over 60% of people living from paycheck to paycheck.In terms of trimming costs, I'm for it in most cases as long as there isn't a sacrifice in quality. I think that's just getting more value. Thus, you can increase your sample size to n=2 :)Regards
We haven't seen the unemployment peak yet. The military is beginning to draw down and will increase in speed within the next two years. I agree with the taxes part. Our city just increased our taxes by $250. per $100,000. WOW! And that is just the beginning. My husband and I set a limit on taxes last night. When it is hit we will sell and move to a lower cost tax area. We are retired and have no interest in the "pretty round-a-bouts" going no where that our city is putting in. Did they forget it is a recession?I would like to say that we have hunkered down- but the taxes on our hunkering is out of control! Our finances are in order- but we cannot control the idiots who run the shop!
Hey Janette, you are right. We cannot control Washington. The politicians have decided that the most financially productive will pay for all of this deficit spending. No one was exercising restraint, and as a result future generations have this huge burden. It is just not right.You and your husband's willingness to move because of tax purposes is just want I am talking about. That deprives your town of two fabulous contributors (financially, culturally, intellectually, etc.).
Thanks for sharing this article. I sure hop it doesn't!
Shawn, thanks for posting the video to help us evaluate Laffer's reliability. Which is a Laff(sorry, I couldn't help it). He drank a lot of Bush Kool-aid. In fact he reminds me of Bush telling us how great FEMA was doing in New Orleans. Maybe we should now listen to Peter Schiff instead. According to Case-Shiller home price index prices are still historically high. Buyers are still waiting for prices to drop and/or their debt ratio and credit scores to improve. This will be a long recession, double dip or not. Our deficit spending is a now necessary evil to prevent a global depression with devastating consequences. We have been letting the wolves run the henhouse for a long time and now the dead bodies are finally visible. You reap what you sow. We voters are reaping our bad choices. Shawn, as a new reader I get the impression that you emphasize living within your means and investing in productivity rather than consumption, which I heartily applaud. Its time to make ourselves wealthy instead of the credit peddlers. Thanks for being another voice of reason.
Thanks so much for posting this comment. Yes, Laffer's record speaks volumes. I don't think this takes away from his brilliance but does give pause when evaluating the reliability of his predictions. After all, a hypothesis is just an educated guess. Unfortunately, there is much modeling pointing towards a slow recession as you mentioned. This is a phenomenal opportunity for anyone who has adequate means to invest (i.e. not broke and over-leveraged).In terms of my philosophy, you got me pegged. I wholeheartedly advocate living within your means and figuring out how to increase your means (income), avoiding debt, and building wealth.I am proud to have you as a new reader. Kind Regards,Shawn
I have never really paid attention to taxes since my income did not require it. That has changed recently, so I pay more attention (due to investments and their tax liability). I would like to know your take on the following:Is it possible that all this money large companies are sitting on could be due to the tax uncertainty?If tax cuts were extended, do you think they would release these funds into the economy?If they did, what kind of an impact do you think this would have on the economy?Thanks in advance.
If the companies chose to take the money as profit, then they would be subject to taxes too, but to take on employees for the purpose of growth in an uncertain economic environment could be quite risky, especially if things turn for the worst initially. I presume this lack of clarity on our national economic state to be the cause of hesitancy in hiring: will our attempts at growth bankrupt our companies?If the tax cuts were extended, I'm still unsure as to what would happen primarily because the present administration is perceived by many businesses and investors as being hostile. With this predominant sentiment, it's hard to say whether extending the tax cuts is enough to assuage fears and release those purse strings. Personally, unless things change, I think we are in for a slow recovery IMHO, which is a lot better than a fast but unsustainable recovery.
One can never be sure of the things to come in the future. but it is for sure that we are in a process of regaining back our financial health. I personally wish that your prediction goes wrong.
Dear Sir/Madam,At any situation we dont need to loose hope and confidence.Its a time for decision.Present Global administrators/policy holders(not leaders) are responsible for this situation.So pls build pressure on them to quit.Every world citizen wants a team of global administrators with honest and selfless person.In past so many big personalities came and build this world by their selfless motive and true honesty.So pls forward my appeal to all.Otherwise really bad days are ahead for almost all in the world so far I understand.Kind rgdsChinmoy Chatterjee from India.+91-9868006099
Looks like we survived, but now we're in 2012. Another year, another test. 😉
We absolutely survived. Here's to a prosperous 2012!
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