The federal budget deficit for fiscal 2009 ended September was $1.42 trillion, up from $459 billion a year ago. Does the record deficit, equal to roughly 11% of gross domestic product (GDP), make higher taxes inevitable? And how would such tax increases affect the stock market?
Over the next 12 months, investors will learn if higher taxes are the cornerstone of the current administration’s strategy for tackling the deficit (versus reduced government spending or “growing” our way out of deficits by reducing taxes to boost personal incomes and corporate profits). At the end of 2010, the current 15% maximum tax rates on dividends and long-term capital gains expire. If the rates are not extended, the long-term capital-gains rate could jump to 20%, and dividends could be taxed as ordinary income at rates as high as nearly 40%.
Regardless of which side of the political aisle you prefer, simple mathematics says that if you increase taxes on investments, you decrease after-tax returns. And asset prices should adjust downward accordingly.
Bottom line: While markets are driven largely by inflation, interest rates, and corporate profits, politics affect all three of these areas. If higher taxes become the political elixir of choice for treating the deficit, don’t be surprised if the stock market turns its nose up at this medicine.