As Earnings Slow, What Will Happen To Taxes?

Rodney Johnson |

Last week, the Census Bureau reported retail sales for December, and the numbers weren’t pretty. Sales dropped 0.1% overall last month, and were down the same 0.1% when auto sales were excluded. Removing volatile gasoline sales only moved the number to flat. Making matters worse, retail sales increased a paltry 2.1% for all of 2015 – the smallest gain since 2009, and well below the 3.9% growth in 2014.

The report justified our negative view on earnings. Fourth-quarter numbers should be ugly. All of this plays right into our forecast for a general market decline and tough economic conditions in the months ahead.

But it also means something else.

Higher taxes.

As Consumers Spend Less, Tax Revenue Falters

Over the past five years, the US budget deficit, as well as those of most states, has improved. Through a combination of higher sales tax receipts, higher tax rates in general and higher capital gains taxes, government entities have pulled in a lot of cash. But the days of easy tax revenue growth are over.

Consumers aren’t spending more, and in some cases are spending less, as noted by retail sales. This cuts into sales tax growth. Falling markets put the kibosh on capital gains tax revenue, which has been a constant source of cash in California, in particular.

These two trends cramp the spending style of governments large and small, leaving them with few options. They can curb their spending (don’t hold your breath for that one), or they can raise tax rates.

As the US economy struggles in the face of a global economic downturn, expect tax rates to move up… and then go even higher.

While Federal Revenue Falls, Costs Keep Climbing...

While falling revenue might cause the federal government and states some short-term pain, the real problem is that their costs keep climbing. It almost doesn’t matter what happens in Congress or in state legislatures across the country. Even if they held their spending flat, costs would still jump because they have non-discretionary expenses such as Social Security and pensions, which are zooming out of control.

The case of the federal government and Social Security is well known, and state pension issues surface from time to time, but the issue at the state level is about to get markedly worse, even as the pension managers make the right moves.

Through September of last year, large pension funds held more than 5.00% of their assets in cash, which is a huge allocation. Clearly, the investment managers of these funds were worried about the markets.

Based on the market action of the last couple of weeks, their caution was warranted. On the face of it, these managers look like investment heroes. Unfortunately, even if they held 100% cash and saved their funds from any losses at all, they would still be losing.

All pension funds have an estimated rate of return. These anticipated gains add to the value of the fund, thereby reducing the contributions required of the plan, participants and employers. Both fund gains and contributions are used to pay benefits. In years where no gains are made, the funds don’t grow, but they still have to pay benefits.

In an odd way, investment managers can be great at sidestepping market land mines, but if they can’t hit their targeted returns, typically around 7.25%, then they are still failing at their jobs!

This might sound like a problem for state pension fund managers and probably state retirees, but the pain won’t end there. Illinois has less than 40% of the money it needs to pay benefits to retirees, and half of all states have 70% or less of the necessary funds.

When these institutions go broke, they won’t simply close their doors and tell pensioners “too bad.” Many of these states guarantee the benefits in their constitutions, which means the burden will fall squarely on taxpayers.

So, as earnings season kicks into high gear, the global economy slows and the markets suffer, remember that governments will still increase their spending.

They’ll just need more of your cash to do it.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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