The New Normal: 10 Themes and Their Implications on the American Economy (Part 2) Tax Inequity

In my previous post I introduced ten themes that represent a "new normal" for the American economy as it continues to exit from the 2007-2009 recession. Evidence suggests that the potentially greatest impact on the economy, and the first theme of the "new normal" is simple demographics. Baby Boomers are getting older, wealthier, more cautious, and  more powerful than ever as a cohort. To them its now about assets not equity; dividends not growth. If the United States recovers to maintain its economic leadership, its largest cohort will likely need to behave differently than any other previous cohort at a similar life stage and throw caution to the wind. More than ever, the American economy needs investment in new ideas, new business models, and the skills of its diminishing workforce in order harness American ingenuity to actually grow its economy. This is not likely to happen because Baby Boomers have accumulated vast wealth and they are unwilling to part with it for any reason.

The second theme is related to the first.

2. Tax Inequity

 The tax holiday to the wealthy, which was introduced almost a decade ago in 2002 while Baby Boomers were in the prime of their productive years are unlikely to benefit the US economy as intended entering into this new decade. As they move towards retirement age, wealthy boomers, which represent 64% of America’s net worth, are more interested in cash (and equivalents like gold) as an asset. As a result, the expected trickle-down benefits of these specific tax breaks are not re-circulating back into the general economy as intended, creating an asset bubble and reducing investment into the broader economy. As an influential voting block, wealthy baby boomers will resist changes to taxation which would not benefit them specifically.

New Normal: Opportunity costs (estimated at between $700B and $900B annually depending upon source) associated with general tax breaks to wealthy Baby Boomers are not paying back as expected, and are unlikely to pay back because the excess capital does return flow into the real economy as intended. Wealthy individuals are less likely to invest in growth, and cannot possibly spend accumulated wealth fast enough to affect incremental economic activity. By redistributing some of the tax benefit to the US Middle Class, spending power increases by as much as $7000 per household.

Risks: Declining growth capital, the deceleration of money and recurring asset bubbles.

Opportunity: Unlock the potential of excess accumulated capital by tweaking tax policy to incent wealthy baby boomers to resist their natural tendencies of their stage of life, and invest in the broader economy. Concurrently, there is an opportunity to redeploy a portion of the tax holiday to spenders, which would probably be described as the “middle class”, representing approximately 55%-70% of the total population (depending upon categorization). A reasonable strategy could be to both incent investment by wealthy baby boomers and spending by the middle class via updated tax policy. It does not look good for the implementation of new tax strategies, as wealthy baby boomers exert their influence on policy.

Investor Sentiment: The probability is low that tax inequity will be resolved soon. The American Middle Class should continue have impaired purchasing power, which should impact negatively on the earnings power of companies that rely on these consumers for growth. Earnings for capital markets could be impaired as cash remains sidelined for an extended period. Although corporate America has been leveraging its massive balance sheet recently for M&A in some sectors such as technology, uncertainty may cause M&A activity to be choppy over long periods. Emphasis on cashflow over growth should be an overhang on employment in the US. Highly efficient operations with growing international consumer and enterprise opportunities are more attractive long positions. Short the American Middle Class.

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