Tax Rates and Revenues

The Treasury announced that it paid down $145 billion of debt in the second quarter versus only $92 billion last year. The budget outlook continues to improve as they estimate only needing to borrow $43 billion in the third quarter. This improvement in the budget deficit can be directly attributed to the huge influx of revenues from capital gains taxes; making it all the more amazing that Democrats in Congress appear serious about letting lower capital gains rates sunset after 2010, if not by active legislation before then. If the maximum capital gains tax rate of 15% on long-term capital gains expire at the end of 2010 we predict huge tax receipts for 2010. But 2011 will experience significant reductions in income taxes. But of course, state and federal government will continue to spend in 2011 like revenues will continue to rise at the 2010 pace. Unfortunately, they won't and deficits will explode. A related story that is likely to develop over the next several years is our government's reliance on upper wage earners for the majority of tax revenues and how that could mean significantly higher revenue volatility. This means that any recession will severely impact revenues. It could become a vicious circle.

The change in tax rates in 1986 are instructive as to what could happen in the equity markets in 2010 and 2011. Rates on capital gains rose after 1986, causing markets to drop nearly the entire fourth quarter of 1986 as investors sold stocks for the favorable tax treatment. Of course, stocks came out the gate strong in 1987, rising over 20% in the first few months. Look for 2010 and 2011 to show a repeat of this, only with a larger magnitude due to the 20+ additional years of accumulated capital gains.