Taxes, Red Tape, & Legislation: Oh, My!

From late April through May every year, I attend a series of conferences, starting with the Milken Institute Global Conference and finishing with the SkyBridge Alternatives (SALT) Conference, the biggest hedge fund conference of the year.

This year, the discussions on the domestic economy focused on the desperate need for stability and predictability with respect to taxes, regulation, and legislation. Businesses will continue to hold on to high levels of cash and will not take on the risks necessary to grow while the future of tax rates remains unclear, regulation keeps expanding unpredictably, and legislation keeps putting more onerous burdens on businesses.

New businesses, the primary source of new jobs, are struggling under the burden of all this taxation and regulation. As you watch the public debates, remember that big business has a strong affinity for anything that makes it tough for potential competitors to enter their industry, thus businesses are often the natural enemy of free enterprise.

Next Jan. 1, the so-called Tax Armageddon arrives, unless Congress whips out an 11th-hour intervention. The long-term capital gains tax rate will increase from 15% to 23.8%, including the 3.8% Medicare tax. Additionally, the distinction between ordinary and qualified dividends will disappear. All dividends will be subject to ordinary tax rates, which mean the maximum rate on dividends will go from 15% to 39.5%.

Federal income tax rates are also set to rise substantially, with the highest bracket jumping from 35% to 39.6%. This means that the highest federal tax rate on investment income will be 43.4% (39.6% ordinary income and 3.8% Medicare). For Californians, add an additional 11% to your income tax for the highest rate. If this increase goes through, it will likely have a substantial impact on markets toward the end of 2012. Investors are likely to try to recognize gains at the lower rates, and much selling is likely to occur.

The recent domestic data is not terribly inspiring, particularly in light of these potential tax hikes.

• Household survey employment has contracted for two consecutive months, despite the unseasonably warm weather, which typically boosts economic activity.
• The percentage of the population in the labor pool has hit a 30-year low. If someone tries to tell you it's because of the aging population, consider this: The number of employed people older than 55 has gone up 3.8 million since 2007, while the number younger than that has dropped 8.2 million. The decline in the workforce is not a result of retirement.
• The unemployment rate for people ages 20 to 24 is 25%! At least we aren't Spain, where the unemployment rate for the same demographic is more than 50%.
• The level of employment is the same as it was 12 years ago, despite a rising population.
• The average monthly job gain since employment bottomed out in February 2010 has been 144,000, making the April 2012 gain of 115,000 look rather grim.
• Real wages have declined in each of the past two months and in four of the past five.
• The number of people on disability or food stamps, as well as the number of people who have given up looking for work altogether, have reached all-time highs.

The vast majority of the speakers at the various conferences expressed grave concern over the loose monetary policies of developed nations, particularly the US, because so many asset prices are related to Treasury bonds. Fed Chairman Ben Bernanke has made it clear in his speeches that the Fed stands ready to use every tool at its disposal if the economy weakens, and that is precisely what we are seeing.

It is impossible to guess what level of economic weakening is necessary to get the Fed involved. But given that this is an election year, it will probably take less than in other years, so don't be surprised to see another round of Quantitative Easing. This can serve as a temporary panacea for the markets, but it is hard to ignore the long-term consequences, so eloquently described by an economist who is widely cited these days.

The best way to destroy the capitalist system is to debauch the currency. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens... The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. -- John Maynard Keynes

Bottom line: After almost four years of $1 trillion-plus fiscal deficits, near 0% interest policies, and a Federal Reserve balance sheet that looks like Octomom pre-delivery, we've still got an economy that is barely breathing on its own. An additional round of QE may provide a short-term boost to asset prices, but at some point, the markets realize that more of the same isn't going to get a different result.