Risk over Reward

A Bi-Monthly Newsletter about Investing

Tax Hikes and Legislation

by Alpha and Vega, an Investor and a Trader
January 15th, 2010

In this issue:
1. The Massive Deficit
2. Looming Personal and Corporate Tax Hikes
3. Other Taxes and Legislation
4. The New Tax Math
5. Implications of a Debt Spiral

Dear Friends, Colleagues, and Investors,

The US deficit is projected to grow by about $10 trillion dollars over the next decade. I’ll
examine the massive federal deficit and the new taxes coming that will help reduce it. I’ll also
look at the biggest financial legislation currently being discussed and how it will impact the
federal budget.

1. The Massive Debt

The Congressional Budget Office (CBO) estimates that the federal deficit will average $1.1
trillion per year for the next decade without tax hikes. This $1.1 trillion represents about 8% of
GDP and assumes that the government’s borrowing rates remain low and that economic
growth returns to historical trend. The CBO warns that this deficit may result in a death spiral of
growing debt that would eventually require the US to effectively default. To make things worse,
states had budgetary shortfalls of about $110 billion in 2009 and will likely face shortfalls of
$150 billion each in 2010 and 2011. There’s also a roughly $1.5 trillion pension shortfall that
may require a federal bailout.

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2. Looming Personal and Corporate Tax Hikes
The Bush tax cuts expire at the end of 2010. This will cause marginal personal income tax
rates to rise 3-5%. Obama’s budget also limits itemized deductions and includes other
provisions that raise about $63 billion in new tax revenue per year.
Healthcare taxes: A “Cadillac Tax” on premium healthcare plans would bring in $15 billion a
year and would affect about 25% of Americans, including 25% of union workers; it is opposed
by many large unions and many not make it into the final healthcare bill.
New taxes on businesses starting in 2011 total about $35 billion a year and include excise
taxes, repeal of subsidies to the energy industry, and a repeal of LIFO accounting.

3. Other Taxes and Legislation

The “Jobs Bill”: a new stimulus bill aimed at producing jobs may include a $250 payment to
seniors, subsidies for transportation and green energy projects, and tax breaks for small
businesses. Early estimates of the cost are $75 - $150 billion. The Senate will begin discussion
on January 19th.
One-time bonus tax: Britain and France have imposed a 50% one-time tax on Bankers’
bonuses. Germany is pondering the idea but looks unlikely to follow. US Congressman Welch
just introduced a similar bill in the US, but it looks unlikely to become law.
Financial Transactions tax: two versions are floating around, one in the Senate and one in
the House. Bill 2927 was introduced late December by Senator Harkin and would impose a
roughly $150 billion a year tax on securities transactions. Earlier in December, a bill titled “Let
Wall Street Pay for the Restoration of Main Street Act of 2009” was introduced by Rep
DeFazio. Both bills impose a tax on stock transactions of 0.25% and on futures and derivatives
of 0.02%. Currently this seems unlikely to pass. I examined the effects of this kind of tax here:
http://www.riskoverreward.com/2009/11/in-support-of-tobin-tax-vega.html
Climate Legislation: We have no idea what this bill will look like if and when it eventually
passes, nor how much it will cost. The burden is on the Senate and climate is currently low on
their priority list. After “Angliagate” and the failure of the Copenhagen climate talks, the
democrats may lack the political will to get involved in another messy legislative fight.
Opponents believe any bill is likely to impose large costs on businesses.
Big Bank Tax: The Obama Administration is pushing for a $90 billion tax on the largest 50
banks. We don't know exactly what form this will take, but it will probably produce be spread
out over a decade.

4. The New Tax Math

These new taxes total about $120 billion in revenue per year. Additionally, the CBO
estimates that current healthcare legislation will reduce the deficit by $10 billion per year.
There are many questionable assumptions built into these numbers; the Obama administration
has discussed extending certain provisions of the 2001 and 2003 tax cuts and we don’t know
what will happen with the Alternative Minimum Tax or what new fees will be imposed on banks;
also, the estimates of health care costs have a giant margin of error. Under these assumptions,
the new taxes (and healthcare deficit reduction) only reduce the annual deficit by about 8%.
Also built into these numbers is an assumption of 3% annual real GDP growth over the next

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decade and 1% inflation. Weaker growth or higher borrowing costs would cause the deficit to
rise even faster.

5. Implications of a Debt Spiral

Eventually, growing fiscal deficits become unsustainable and it appears the US may have
already entered a debt spiral. Japan successfully maintained a debt to GDP ratio of 150% for
over a decade, so it’s not obvious when a high sovereign debt level will lead to crisis. Japan
was able to maintain such a high debt level for so long at least in part because the Yen was an
international reserve currency and Japanese citizens maintained an extremely high savings
rate (financing Japan’s debt at low interest rates). The US has an even stronger reserve
currency, and if we enter recession again the savings rate may skyrocket. In other words, we
may be able to survive in the debt spiral for quite a long time. However, eventually we will have
to either sharply devalue our currency or find some other way to default on the unsustainable
debt. The other option, raising taxes and decreasing expenditures, would require sacrifices so
great they seem politically impossible.

The Yap live on a small collection of islands in the south pacific. As money, they use giant
stone wheels called Rai (pictured above). Maybe after the US devalues the dollar into
worthlessness we’ll all be using stone wheels as money. I can picture the commercials – giant
stone wheels 4 gold!

Your “stone wheel hoarding” Trader,

Vega
vega@riskoverreward.com
Copyright 2010 Risk Over Reward. All Rights Reserved

Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty,
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