By David R. Guttery, RFC, RFS, CAM
President, Keystone Financial Group – Trussville, Ala.
David R. Guttery
Thankfully this election cycle is behind us, and with it I believe we have greater clarity today over what might happen next with the gradual positive economic momentum that we have observed building throughout the year. Look, to preface let me just say that I’m thankful to live in a free country where we all have the right to see the world through our own prism. My comments are not to be taken as a political referendum, but rather as an economic observation. This is about financial physics.
I believe that you have three types of voters. Voters are typically motivated by economic issues, social issues, or civic issues. My comments will be limited to the economic issues that may have played a part in the outcome of the election. Remember, markets aren’t red or blue. They just want to know what the rules are. Well, until just a few weeks ago, we had very little idea of what those future rules might be.
A few months ago, I attended a conference where Baker Hostetler offered a keynote presentation on this topic. They are a national tax law advisory firm, and each year we have the privilege of receiving their input on tax and legislative issues that may impact our industry. In summary, I will tell you that it was a very sobering presentation. In their opinion, there was a great likelihood that the tax cuts and jobs act would be allowed to expire. When coupled with increased spending in recent years, national debt had reached an unsustainable level in their opinion, and given the pending election, the stage was set for the potential of having very impactful tax law changes in our immediate future.
Over the last year, the mass media has vetted this election from every conceivable angle. In my opinion, there was one very obvious consideration that garnered very little attention, and frankly, I thought it was one of the most major concerns from the perspective of economic growth. The potential for massive tax law changes in my opinion was a metaphorical time bomb upon which no one was fully aware that we were sitting.
Think about how difficult it is to get anything passed through Congress. It seems that sometimes Congress can’t agree on what day of the month it is even while looking at a calendar. Consider that the current administration has had four years to unwind the tax cuts and jobs act. In two of those four years, the current administration had the benefit of the majority of Congress and they still could not unwind the tax cuts and jobs act.
Question. What would it take from here to bring about the most impactful change in tax law since the tax Reform Act of 1986? Answer, nothing. Zero. Not one single vote would need to be cast. The only thing that would be necessary for that to come about, is gridlock. Continued arguing. Had that happened, then both the tax cuts and jobs act would have expired, along with the sunset of the estate tax repeal in the following year.
The impact of those two pieces of major tax legislation sunsetting in back-to-back fashion would have had an enormous impact on our ability to consume. Consumption is 70% of gross domestic product, so by extension I believe this could have had detrimental implications on the positive economic momentum that we have seen building this year.
Until the 5th of November, we had very little clarity about this matter, and therefore I believe until just very recently we had very little clarity regarding the future direction of the economy.
The late Paul Bear Bryant once said of the forward pass, when you put the ball in the air, three things can happen, and two of them are bad. Well, from an economic perspective, there were three possible election outcomes, and as it pertains to tax law, two of them were bad.
As with any election, there were three possible alternatives. The Republicans could sweep, or the Democrats could sweep, or we could continue to experience divided government. In the opinion of Baker Hostetler, the odds of a Republican sweep were very low, and the least likely of the three outcomes. This led most industry economists and analysts to assume that the tax cuts and jobs act would likely expire.
In the first scenario, the Republicans sweep and as a result we could assume that most of the tax cuts and jobs act would likely continue in its current framework. Having said that, the government remains thirsty for revenue given the spending that we’ve observed over the last four years, so now the question remains to what degree might the tax cuts and jobs act be tweaked or modified going forward. That remains to be seen.
In the second scenario, the Democrats sweep, and in this case the assumption was that the tax cuts and jobs act would be allowed to expire, and possibly replaced with a more onerous tax burden. Again, Congress seems unable to agree on much of anything, so how do you raise the greatest amount of tax revenue in the shortest amount of time? You allow the current tax code to expire and reset to where it was in 2016. Also, in this scenario we heard from the campaign trail about higher marginal rates of income taxation, and higher rates of taxation on corporations, and other plans that called for the taxation of unrealized capital gains for example.
In the third scenario, we remain with the divided government. As a general rule, markets like gridlock because rarely do the rules change under such circumstances. In this case however, a divided government would have also likely resulted in the expiration of the tax cuts and jobs act. So, again referencing Coach Bryant, of the three things that could have happened, from a tax perspective, two of them were bad if you are concerned about the future for economic growth.
Think of Usain Bolt. The fastest human on earth. He holds the world record for the 100 meter sprint with a time of 9.58 seconds. If I were to put a backpack with 10 pounds of rocks on his shoulders, I doubt that he could run the same time. He could still outrun me, but probably not beat his world record. The more weight you put on the runner, the slower he will run. The more weight you put on the economy, the longer it will take for positive economic momentum to gain traction, and indeed, it might not move forward at all.
There were quite a few of them, but I can offer some major bullet points that were of greatest concern to me as a financial planner, and considering the impact of a potential change in tax law on the direction that we might take from an investment management perspective going forward.
First, had the tax cuts and jobs act been allowed to expire, then we go back to the previous tax code that was in place prior to its passage. By definition, this meant that tax collections from individuals could increase by 10% in 2026, and 11% in 2027. That is a significant increase in cumulative tax liability, and this tax liability would have been felt across the board. Regardless of your occupation, had the tax cuts and jobs act been allowed to expire, then liabilities of personal income tax would have risen universally by definition.
Second, the repeal of the estate tax could potentially sunset on the heels of the tax cuts and jobs act sunsetting the very next year. If this happens, then among other things we would go from having a $14 million portable unified credit, to a $7 million nonportable unified credit. The rate of taxation due on the first dollar above the lower unified credit is taxable at a significantly higher rate than it is today, if this sunset is allowed to happen. Therefore, revenues are projected to increase by 40% in 2027 through the sunsetting of this tax measure alone.
Third, the qualified business tax deduction hung in the balance as well. This could have potentially impacted plans for expansion, and employment. If this results in fewer people being employed, then those people are without an income, which clearly impacts patterns of consumption.
Fourth, the expiration of the tax cuts and jobs act could have had a significant impact on the method by which new businesses organize. It would have likely also had a major impact on foreign investment activity as well.
These are just some of the major highlights that I believe would have resulted from the sunset of the tax cuts and jobs act. Again, no one in the mass media was really talking about this, but in my opinion, it was one of the most impactful considerations of the election.
Had this been allowed to happen, each individual tax bracket would have reset to where it was prior to the passage of the tax cuts and jobs act, and therefore by definition, tax liabilities across the board would’ve increased.
Assuming that you don’t itemize, the standard deduction for a married couple would have reduced from $24,000 to $13,000. Again, by definition, if you are deducting less from your taxable income, then relative tax liability increases.
I drew reference to the impact that would be felt from the expiration of the current repeal of estate tax law. Among other things, the amount of money that could be passed to heirs would likely be lower if the unified credit were to be cut in half, and the rate of taxation on the first dollar above that unified credit increased substantially.
Assuming that these changes occurred, then I would also assume that an increasingly greater number of tax filers could find themselves subject to the alternative minimum tax. Clearly, that isn’t a positive development.
So again, much hung in the balance from an economics perspective when it came to the election, and now that the event is behind us, I believe that we can look forward with greater clarity and make assumptions about the economy with greater confidence.
I am much more confident that the sluggish, but positive economic momentum that we have observed this year could potentially gain momentum and strengthen from here.
The consumer price index continues to float downward, and according to the Department of Labor, household income is rising at a rate that is higher than the rate of inflationary change, and this is a trend that we have seen billed now for 24 straight months. Capacity to consume continues to widen in other words, in looking at the last three quarters of retail sales, it would appear that the average household is feeling better about their ability to consume. As evidenced by the last two rate cuts, the Federal Reserve seems to have shifted to an accommodative monetary policy stance, so the cost of carrying leverage could potentially be lower from here, and that will be a positive development for areas such as housing.
So long as a significant change in the rate of taxation paid by those households does not undermine this trend, then I think we can reasonably assume that it will continue. As you buy more things at the store, the manufacturer of those things must replenish the supply. If I manufacture that widget, I am increasingly more concerned about the capacity of my plant to make more of that which you are demanding a greater quantity. Therefore, I am going to be increasingly incentivized to hire more people, to pull the levers and push the buttons, to make the widgets, to restock the shelves.
Assuming the government does not take an increasingly greater percentage of that revenue dollar away from me, then this positive feedback loop is likely to continue in my opinion. In the first full year of the tax cuts and jobs act, the U.S. Treasury reported record nominal receipts. Part of the reason for that was a much higher velocity of money. This is the frequency with which a dollar circulates through the economy. The higher the frequency with which a dollar circulates through the economy, the more times it is taxed, thus resulting in the greater nominal receipts that we observed in 2019.
I believe that we could see this phenomenon repeat itself as the economy continues to emerge from the post coded pandemic economic fallout. To me, the election was a pivotal part of this equation because of how two major pieces of tax legislation hung in the balance. Now that this is behind us, I believe that we can assume that the economy is likely to continue on this path of positive recovery.
Clearly, there are still geopolitical issues with which to contend, and the Federal Reserve does continue to unwind its balance sheet, and the likelihood of achieving a soft landing remains to be seen. We’re not out of the woods yet, but the visibility through the windshield, in my opinion, just became much more-clear.
I would like to close by reminding everyone watching this video that where you are today is not as important is where you will be tomorrow. The greatest concern is how you are going about the achievement of long-term planning goals. As I have mentioned in previous videos, please insulate yourself against sensationalism and hyperbole. Focus on that which can be quantified, and have a stoic disposition as you apply that data to the implementation of your plan. This is truly a marathon, and not a sprint. It is at times such as these when we would all benefit from that reminder.
(*) David R. Guttery, RFC, RFS, CAM, is a financial advisor, and has been in practice for 33 years, and is the President of Keystone Financial Group in Trussville. David offers products and services using the following business names: Keystone Financial Group – insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA / SIPC – securities and investments | Ameritas Advisory Services – investment advisory services. AIC and AAS are not affiliated with Keystone Financial Group. Information provided is gathered from sources believed to be reliable; however, we cannot guarantee their accuracy. This information should not be interpreted as a recommendation to buy or sell any security. Past performance is not an indicator of future results. Examples are for illustrative purposes only and should not be considered representative of any investment. Investments involve risks, including loss of principal.
