Which way the taxation winds are blowing: Part 2

(Editor’s note: This is the second of two parts. Read Part 1.)

Steve Wyett, senior vice president of portfolio management at BOK Financial, said recently that the Congressional Budget Office is predicting the budget deficit in 2013 to go to $642 billion, a $200 billion improvement. He called the deficit “unsustainably large. We’ve got to reduce that gap.”

Taxes control budgets, which control spending, which controls deficits; so if the government is going to attack the deficit it has to cut spending or raise taxes. The administration wants to raise taxes on high earners by: reducing itemized deductions to 28 percent for families in the top three income brackets; imposing the Buffet rule where millionaires pay no less than 30 percent of their income in taxes; and capping IRA account values.

On the revenue side, the biggest effect would be to change how the government measures inflation from the Consumer Price Index to a “chained CPI,” seen as a more accurate measure because it takes into account how people buy cheaper items when stressed. Chained CPI has the effect of lowering the inflation measurement, and this would lower the inflation-adjusted increases of Medicaid and Social Security benefits. Therefore, the government would spend less. It would also slow the increase in inflation adjusted allowable deductions for high earners.

Estate Planning

In the estate planning area, the administration wants to, beginning in 2018, return the generation-skipping transfer and gift tax exemption rates to 2009 levels, with a top rate of 45 percent and an exclusion amount of $3.5 million (down from $5.2 million) and $1 million for gift taxes. The President also proposes to reduce the life of a trust from 1,000 to 90 years, thus reducing generation skipping tax exemptions. It’s worthwhile to note these measures have been proposed in years past; it will be difficult to lower the exemption from $5.2 million since it has been in place since 2009.

Effect on investments

Given this tax and spending backdrop, what is an investor to do in 2013? Wyett said that the traditional haven for the wealthy — corporate and municipal bonds and government securities — are a bad choice. In fighting deflation,  the government easing of the money supply has been the response and will continue to occur until unemployment is 6.5 percent and prices are stable, say at about 3 percent inflation. When inflation and interest rates inevitably rise, the principal value of bonds will decrease; plus that 2 percent Treasury note coupon won’t look so attractive against an even modest inflation rate.

“Despite highs in the S&P and the Dow, stocks will provide the opportunity for growth. Bonds provide no growth opportunity,” Wyett said. “If I buy a $100,000 bond today, it’s going to mature in 10 years and I know exactly what I’m going to get, absent a credit event: 100,000 bucks.”

He noted the average earnings ratio on stocks is at 14 percent, below historical highs.

“Bonds are not riskless. We don’t believe higher interest rates are a 2013 story, maybe not even 2014, although we hope they pull back on quantitative easing,” Wyett said. “The longer your investment horizon, the more favorable the outlook is for equities than bonds.”

But don’t forget the government seems more bent on promoting investment on small business and on taxing passive investments. It already raised capital gains to 20 percent and high earners get to pay 3.8 percent more of taxes on investment income. Oh, well – at least we know that nothing is permanent when it comes to taxation. If your investment horizon is longer than a few years, the picture will likely be different when it comes time to cash in.