Tags: tax | economy | growth | GDP

Tax Receipts at 18 Percent of Economy May Point to Business Slowdown

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Friday, 24 April 2015 11:18 AM Current | Bio | Archive

With "tax day" now firmly behind us, 2015 is expected to show a record level of tax collections. This is a good thing, right? Maybe not.

Over the weekend, an economist friend of mine sent me an interesting analysis that discussed the record level of tax receipts as a percentage of the economy.

While the current push higher in tax collections is partially the result of economic growth, it is primarily due to higher tax rates implemented in the 2011 Budget Control Act. That bill imposed automatic tax increases and spending cuts beginning in 2013.

Interestingly, Ben S. Bernanke, the chairman of the Federal Reserve at the time, launched the third round of quantitative easing specifically to offset the potential risks of the "fiscal cliff" imposed by the "debt ceiling deal."

The good news is that those tax increases and automatic spending cuts led to a massive reduction of the deficit, which has declined from a record of $1.35 trillion in 2010 to just $559 billion at the end of 2014.

While it is certainly good news that the budget deficit is shrinking from a "fiscal" perspective, the economic ramifications are not so great.

The reason: "The economy is not growing strongly enough to offset the drag caused by fiscal austerity."

Government spending was a support of economic growth prior to the onset of the fiscal cliff. While President Obama currently takes credit for the shrinkage of the deficit, it was due to no actions of his own but rather a complete snafu brought about by the ongoing guerilla warfare between the Democrats and Republicans.

The austerity measures automatically imposed by the Budget Control Act of 2011 became a drag on economic growth as the rise in tax collections reduced the effect of consumption and reinvestment in the economy.

While raising taxes may increase revenue in the short run, over the longer term higher tax rates lead to lower economic growth. If more dollars are extracted through taxes, there is less available for consumers and corporations to utilize.

While tax dollars do get recycled back into the economy, repeated studies have shown that government spending has a much lower "multiplier effect” than dollars spent directly by consumers and businesses. Taxes as a percentage of GDP have historically peaked between 18 percent and 20 percent. Now, let's compare that to actual economic growth rates.

Rising levels of tax receipts have coincided with stronger levels of economic growth in the early stages which is not surprising as more revenues lead to higher collections. However, once those collections exceed 18 percent of GDP, it has generally marked the peak of economic activity before becoming a subsequent recessionary drag.

While there are many calls to raise taxes on the rich and give more to the poor, none of that really makes much difference.

Regardless of the level of tax rates — tax receipts as a percentage of the economy have remained mired between 16 percent and 21 percent. Why? Because when you raise taxes, you lower economic growth and, therefore, collect less in revenue. During recessions, tax collections are at the lower end of the range while during expansions collections are at their highest.

So, what does all of this mean? As Tom McClellan recently noted:

"As Arthur Laffer noted 3 decades ago, it really is possible to set tax rates too high such that it actually hurts the economy. We appear to be in such a condition now. I wrote about this topic back in January, when lawmakers were contemplating raising the tax on gasoline. But it is worth revisiting as we see total federal receipts creeping up toward 18 percent of GDP. Whenever total federal tax receipts have exceeded 18 percent of GDP, the result has always been a recession for the U.S. economy."

Comparing the S&P 500 stock index with the percentage of tax receipts shows that each peak in tax collections has coincided with a mean-reverting event.

While many people expect that the markets can repeat the secular bull market of the 1990s, and by extension receipts could test the previous high, Tom makes a salient point as to why this is not likely.

"In 1999, the members of the Baby Boom generation (born 1946 to 1964) were between 35 and 53 years old, in the peak of their entrepreneurial years. They were working hard, building companies and pushing the economy faster than it would normally go. Now, they are 51 to 69 years old, and are more interested in playing with their grandchildren than in starting a new company and hiring people.

The children of the Baby Boom generation make up what is known as the 'Echo Boom,' which peaked in the birth year of 1990. Those 1990 babies are now just 24 to 25 years old, and many are just now moving out from their parents’ homes. So they are not quite at their peak of hard work and entrepreneurialism, and even when they do reach that point, their numbers are just a shadow of their parents’ generation. So the Echo Boomers cannot absorb the same degree of a repressive tax burden that the Baby Boom generation could."

This, along with a variety of other reasons I have addressed previously, suggests that the current economy and market are likely at their later stages of expansion currently. As Tom concludes:

"And we need to keep the federal receipts number well below 18% if we are to avoid the next recession, and its associated downturn in stock prices. We may already be too late in that regard."

Tax receipts are clearly issuing a warning sign. However, as is always the case, you cannot make short-term investment decisions based on very slow-moving economic variables. This has been a common mistake made by investors.

Irrationality and exuberance, along with massive central bank interventions, can keep asset prices inflated for far longer than logic would dictate. This is why technical analysis is so critically important to understand near-term price trends.

It is unlikely that stocks have "reached a permanently high plateau," or that this time will resolve itself differently. Eventually, reality and fantasy will once again reconnect and throughout history it has never been reality doing the "catching up.”

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LanceRoberts
While raising taxes may increase revenue in the short run, over the longer term higher tax rates leads to lower economic growth. Once collections exceed 18 percent of GDP, it has generally marked the peak of economic activity and a subsequent recessionary drag.
tax, economy, growth, GDP
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2015-18-24
Friday, 24 April 2015 11:18 AM
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