- Midterm elections are right around the corner, and the tax debate has been steadily heating up—will the Bush-era tax cuts be extended?
- A tax-cut extension may or may not happen, but investors needn't worry much either way—history shows neither tax cuts nor hikes particularly affect stock returns.
- Positive fundamentals are likely to outweigh any tax concerns and continue driving stocks and the economy higher.
Midterms are just around the corner and the tax debate has been gaining steam. More specifically: Will the Bush-era tax cuts be allowed to sunset? Undoubtedly, politicians (both red and blue) will use the issue to curry favor—expect to hear endless rhetoric on the tax cuts on the campaign stump. But pragmatically, it's just one market driver among many investors must weigh.
In a perfect world, there's not much to dislike about tax cuts—and in our view, it would be nice to see the cuts extended. A marginal tax increase or decrease will assuredly affect incentives to work and, therefore, economic growth and government revenues. Increase taxes, and there's less motivation to work more and earn more. Economic growth could slow a bit as a result and government revenues suffer.
Positively, though lawmakers could still very well allow the cuts to lapse, the likelihood is less now than it was earlier this year. The Democrats have already softened their position by advocating extending the cuts for household incomes under the much-demonized $250,000 level. Some conservative Democrats have even proposed raising that limit to incomes under $1 million. Democrats are very likely to lose relative power in the midterm elections and may be forced to bargain more than they've been accustomed to lately in order to get anything done. And the Bush tax cuts make a prime bargaining chip, particularly if economic worries continue.
We could debate endlessly the likely direction Washington takes on taxes, but either way, rational analysis says it's not life or death for the economy or stocks. For one, consider the magnitude: We're not going from 0% taxes to 90% taxes or vice versa. In the grand scheme of things (and , again, we'd always root for lower taxes), the marginal increase is not massive. Second, the historical case for tax changes affecting the market is mixed—neither consistently showing great returns after a cut nor particularly poor returns after a hike. And never forget to think globally. Even if the US insists on uncompetitive tax policies, the US isn't the world—not even close. If anything, a US tax increase is yet another reason to invest globally.
Investors must constantly weigh negative and positive market factors—one negative factor alone shouldn't be enough to make a convincing case. For now, positive fundamentals (e.g., huge profit growth, historically liquid corporate balance sheets, gangbusters Emerging Markets growth, shrinking stock supply, and too-low investor demand, etc.) will likely outweigh any concerns surrounding US tax cuts or hikes and continue to drive the global stock market higher.