Watching the IRS

Conclusion: Keep your Hedgeyes on the IRS and how 2011's tax rate increases will affect the economy at large. Expect more attention to be paid to this as we progress through the year, and for it to be priced into the markets as early as this summer. 

 

With sovereign debt concerns, the EU bailout package, accelerating inflation, and fat fingers garnering so much investor attention globally, we thought  we'd give you a quick global macro break and focus you on a domestic issue that will become increasingly important as 2010 progresses - 2011 tax hikes.

 

Since I collected my first paycheck some 8-9 years ago, I've been duly focused on taxes - i.e. how much of the money I made I wasn't actually going to be able to spend. After all these years (joke), the only thing I've come to learn about taxes is they don't get less annoying with time. And in 2011, I expect to become even more annoyed (along with a lot of other taxpayers).

 

Changes to be enacted in 2011: 

  • Income tax brackets are scheduled to change for 2011, with the highest rate increasing from the current 35% to 39.6%. Each of the lower brackets will also be increasing. It has yet to be determined where the income threshold will be for each bracket, but taxpayers can rest assured that their federal tax burden will be increasing for 2011; 
  • Capital gains tax rates are also scheduled to change. The top rate for long-term capital gains is expected to rise from 15% to 20%; and 
  • The preferential qualified dividends tax rate of 15% is scheduled to expire, so all dividends will be taxed at ordinary income tax rates. 

Obviously, this will be a headwind for the American consumer and will have negative implications for discretionary spending in 2011 (we may see a marginal pull-forward in spending on larger-ticket purchases this year as consumption is all but sure to decline next year). Less obvious, however, are the implications the tax rate hikes will have on the certain markets and M&A activity.

 

Under the new tax structure, we could see investment money flow towards capital gains away from equity income - especially those monies that will be taxed at or near the highest rate (39.6%). With so many retirees dependent on dividend funds, however, Congress may be inclined to level the playing field by either raising capital gains taxes or lowering the tax rate on dividends. Time will tell on that matter.

 

The far right column of table below shows the Y/Y percentage change in the after-tax income from a variety of investment sources. We have used the top tax bracket as a proxy for wealthy investors, simply because the flow of their monies will have greater impact on the overall investment community.

 

 Watching the IRS - Taxes

 

It is important to also note that municipal bonds and municipal bond funds will become more attractive on the margin vs. taxable bonds and taxable bond funds. While we believe the state budget and U.S. sovereign debt issues will have a greater impact on municipal bonds inflows, we'd be remiss not to call out this additional tailwind for the investment vehicle.

 

Regarding M&A activity – which should pick up with capital gains taxes headed higher – private businesses will be looking to sell prior to the tax rate hikes, and, as the year progresses, those looking to acquire with cash will have a more favorable environment. Sellers will certainly feel the pressure to unload by year's end rather than face a 33.33% higher effective tax rate in 2011. Aware of this selling pressure, buyers equipped with cash will be hunting for discounts late in the year. As an aside, buyers looking to acquire with deferred payments may be subject to a premium to offset the seller's increased 2011 tax burden.

 

In short, keep your Hedgeyes on the IRS and how 2011's tax rate increases will affect the economy at large. Expect more attention to be paid to this as we progress through the year and for it to be priced into the markets as early as this summer.

 

Darius Dale

Analyst


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