An April 15th Look at Taxes and the Stock Market

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Tax policy can impact not just how much money you pay in taxes, but how much money you are likely to make in the first place if you are an investor. U.S. capital gains taxes have risen and fallen over the last one hundred years and the stock market usually follows the direction of rates. A significant rate increase will be taking place on January 1, 2011.

The reason capital gains are taxed at different rates than ordinary income is that investing involves risk and capital will not flow unless risk is adequately rewarded. Lower capital gains tax rates encourage more business formation and expansion and bring more capital into the stock market. This is the source of real economic growth. Taking on risk to obtain gain of course means the possibility of loss as well. Uncle Sam is more than willing to demand his share of your profits if you make money, but is no longer your full partner when you experience losses. If you make a million dollars investing, you pay taxes on that million dollars. If you don't have trader status with the IRS and lose a million dollars, you get a $3000 deduction per year and will certainly be dead long before you use it up.

Originally, capital gains were taxed at the rate of ordinary income between 1913 and 1922. Top marginal rates were only 7% at first, but rose to as high as 77% in 1918 to pay for World War I.  An alternative capital gains rate of 12.5% for assets held at least two years was introduced in 1922. The top marginal tax rate on earned income was lowered to 25% in 1925. It was an era of low inflation and even deflation starting in the late 1920s. The stock market and economy did quite well; at least for seven years after the lower capital gains rate was introduced.

In 1932, when Herbert Hoover was still president, the top marginal tax rate on earned income was raised to 63%. In 1934, capital gains tax rates were changed and based on how long an investment was kept. For assets held 1,2, 5 and 10 years, the exclusions were 20, 40, 60, and 70 percent respectively. In 1942, top marginal tax rates were increased to 88%, but maximum capital gains rates were capped at 25% for assets held for six months or longer. Top marginal rates went as high as 94% in 1944 and 1945. They remained at 91% or 92% until 1963. The huge differential between marginal rates on earned income and capital gains rates along with low inflation created an economic and stock market boom that lasted from 1942 until the late 1960s.

The top marginal rate was lowered to 77% in 1964 and then 70% in 1965. Capital gain rates were raised in 1969. Inflation began picking up at around the same time and the combination was a negative for the economy and stock market for over a decade. The government made the problem worse by raising capital gains rates significantly in 1976 and added insult to injury by taxing gains that only existed because of inflation. Maximum capital gains rates peaked at just under 40% in 1977 and 1978.

In 1978, congress voted to reduce maximum capital gains to 28%. In 1981, capital gains were lowered to 20% and the top marginal tax rate to 50% starting in the 1982 tax year. The high rates of inflation from the 1970s were beginning to decline significantly. An almost 20-year boom period followed. There were bumps along the way however. The 1986 Tax Reform Act increased capital gains rates to 28% and lowered the top marginal rate on earned income to 38.5% starting in 1987. The marginal rate was lowered further to 28% in 1988. Ironically, equalization of earned income tax rates and capital gains, a long sought goal of certain liberal economists, took place during the Reagan administration.  The U.S. stock market zoomed for the first eight months. Unfortunately, it then fell almost 40% in a few days in October.

Marginal rates started rising in 1991 and reached 39.6% by 1993. The Taxpayer Relief Act of 1997 reduced maximum capital gains rates to 20%, once again creating a significant differential between earned income rates and capital gains. Inflation was falling and low during this time and this kept the real capital gains rate close to the official one. The stock market and economy did extremely well for the next three years until the tech bubble burst. To pick up the flagging economy and stock market, the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced maximum capitals gains rates to 15% and made this the rate for qualified dividends as well. Inflation was very low during this period. The market and economy did well for the next four years.

Now the maximum capitals gain rate is scheduled to increase from 15% to 20% after the end of the year. Additional taxes will be imposed later on because of the recently passed health care legislation. It looks like we are entering a period of rising inflation and this will make the actual capital gains rate continually go up. I will leave it to the reader to decide what impact this will have on the U.S. economy and the stock market going forward.

Disclosure: Long oil.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Welcome to Hyperinflation

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our Video Related to this Blog:

Yesterday ZIRP (zero interest rate policy) became a reality in the United States. The Fed cut its overnight funds rate to a range of zero to 0.25 percent. The New York Investing meetup predicted such a possibility in the fall of 2007, when I first said that if things became bad enough the Fed would lower interest rates to zero. In our December 4th meeting two weeks ago, we predicted that 2009 would be the year of ZIRP with the Fed lowering interest rates to around zero and keeping them there. Things apparently have become bad enough.

Yesterday, the Fed bluntly announced that it would print as much money as necessary to deal with the current economic contraction (read depression). And this has allowed the American press to finally acknowledge in its articles that the Fed has been printing money to cope with the credit crisis - something that I have been repeating like an obsessive-compulsive parrot for more than a year. Since this September alone the Fed's balance sheet has more than doubled (that's in only 3 months... think about that) from around $900 billion to more than $2 trillion. With its new programs to buy up worthless mortgage-backed securities that number will be up to $3 trillion. You may safely assume it will go much higher after that.

The authorities and their allies in the mass media assure us that we needn't worry about the obvious (hyper)inflationary implications of the Fed's moves. It is claimed that deflation is the big problem facing us (and War is Peace and Hate is Love, etc. see Orwell's novel 1984 for similar government assertions). The facts, as well as simple common sense, indicate otherwise. The government's own highly manipulated numbers which grossly understate inflation, still indicate prices are going up. The big drop in price increases can be traced to falling oil prices and literally nothing else. Since commodities can only fall to their cost of production, oil is not likely to fall much further and the 'deflation' threat could disappear overnight. The market will then have to deal with a mountain of government printed money instead.

Apparently we needn't worry about that either. While the economic establishment admits that the Fed's actions are potentially dangerous, former Fed Vice Chair Alan Blinder himself said yesterday "If that much money is left in the monetary base, it would be extremely inflationary", it claims the money can be withdrawn as the economy recovers and then everything will be fine. The German authorities said the same thing about their money printing in the early 1920s. But every time they tried to stop it, there was an immediate negative reaction in the economy, so they restarted it again immediately. The U.S. Fed in the 2000s will be no different. Money printing is a form of addiction and addicts will do anything to maintain their high until they hit bottom.

NEXT: The Truth About Deflation - A Crude Analysis

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Unemployment - Truth Worse than Even Government Reports

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our Video Related to this Blog:

Today's weekly jobless claims came in at 573,000, well above the cut off of 400,000 level which is usually considered recessionary. The four-week moving average, which is considered more important because it is assumed that the errors in each weekly report will cancel each other out, came in at 540,500. Continuing claims, all the people who are collecting unemployment, reached 4.43 million. Both numbers are the highest level since the deep recession of 1982 when official unemployment reached double digits. The increase in people on the unemployment rolls was the biggest since 1974, another year of major recession and a major bear market.

While no one could argue that these numbers aren't bad news, the truth is actually much worse. Somewhat less than half of the American labor force is eligible for unemployment. This part of the population never shows up in the official numbers cited above. This does not mean however that you can just double all the government figures to get at the true numbers. You would have to assume that the half of the U.S. labor force not eligible for unemployment is equally likely to be unemployed as the half that is and this is certianly not true. On the other hand, it is also certainly true that the ignored half or the labor force does not have an unemployment rate of zero.

The monthly unemployment figures published by the BLS also underestimate unemployment, but do so in a different way. People who are "no longer looking for work" also known as discouraged workers are not counted. The underemployed or people who have worked even a minimal amount part-time are counted as employed. The Labor Department does publish an alternate measure of unemployment, which counts part-time workers who want full-time work, as well as anyone who has looked for work in the last year. This number which still cuts out a number of people indicates that the current U.S. unemployment rate is closer to 13%, not the 6.7% officially reported in last months employment report (almost double, but not quite).

In times of great economic calamity for developed economies, unemployment can reach a quarter of the labor force. It was estimated to be 25% at the bottom of the U.S. Great Depression in the 1930s and almost that same number during the hyperinflationary collapse in Germany in the early 1920s. If the alternative unemployment figures reach 20% or more this time around, it can safely be said that the current economic crisis has gone beyond recession and has become a depression.

NEXT: Herbert Hoover Policy - Working Just as Well Today as in the 1930s

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The Inflation Versus Deflation Argument - Part 5

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

If the deflationists aren't really discussing consumer price inflation, what is it that they are really talking about? To figure this out, it is helpful to seperately analyze the two components of the deflationist argument, bank credit and money supply, since they operate in very different ways and combining them obfuscates the picture.

Since people don't take out a bank loan to buy a quart of milk or a tank of gas, but they do borrow to buy a house and financial instruments, there is a direct relationship between bank credit and asset prices. The effects of increases or decreases in bank credit are likely to show up relatively quickly in prices for real estate, bonds, and stocks. Only much lately are they likely to impact consumer prices and even then they will represent only one of many components (currency exchange rates being potentially far more important).

This proposed direct relationships between credit and asset prices and currency and consumer prices seems to be well supported by real world observations. In the late 1920s U.S. there was a massive increase in credit and strong bull markets in housing, stocks, and bonds, yet consumer prices were dropping. Even though the U.S. currency didn't float at the time, capital was flowing into the New York from around the world and if the value of the dollar had been market driven, it's exchange rate would have been rising. A similar picture exists for Japan in the 1980s, although there was an even more massive asset bubble and the Yen was experiencing a far more significant rise that the U.S. dollar would have had in the 1920s.

In contrast, the U.S. in the 2000s was a period of declining currency values, the dollar peaked in 2002 and lost more than a third of its value by 2008. Bank credit expansion during this period led to massive bubbles in real estate and related debt instruments, with the S&P testing its 2000 bubble high in late 2007. When bank credit began its severe retraction, prices for real estate, non-government bonds, and stocks had significant drops. Consumer prices on the other hand accelerated higher. One major reason was the rising price in commodities. Since commodities are priced in dollars, they will go up if the U.S. dollar goes down.

The other component of the deflationist argument, money supply, has an obvious lagged effect on consumer prices. Changes can show up many years later. An examination of a money supply chart from the 1970s illustrates this quite clearly. M3 growth peaked in 1971, yet U.S. consumer price inflation didn't have an intermediate term peak until 1974 and the final high wasn't reached until 1980. The large rise in M3 in 2008 isn't likely to have its full impact on consumer inflation until some time in the 2010s.

Since deflation inevitably follows serious inflation, the deflationists at some point will be correct that there will be deflation in the United States. Worrying about deflation now though is like closing your windows and turning up your heat in May because you are worried about a cold winter coming.

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:http://investing.meetup.com/21/Files

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

For more about us, please see our web site: http://investing.meetup.com/21