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When stock prices slide and gains evaporate, investors are usually left with the meager consolation of smaller tax bills. If a long stock decline were to hit now, however, investors could easily be required to pay more.
The problem is that the stock market has become an important source of consumer stimulus and government revenues, and bullish assumptions about stock returns have been built into state pension math. A prolonged market downturn could thus set off a chain of effects that would end with sharply higher income taxes.
First, consider the background. Federal debt held by the public has swelled 81% in three years to $9.8 trillion as of Monday. In March, the Congressional Budget Office projected that the U.S. will run deficits of (and therefore have to borrow) about $7 trillion between 2012 and 2021. Tuesday's signing of the Budget Control Act of 2011 will ultimately reduce this amount by at least $2.1 trillion, the CBO estimates. That leaves nearly $5 trillion in looming deficits to deal with. However strong the case for spending cuts, tax hikes seem inevitable, because federal revenues are low by historical standards -- 15% of gross domestic product, versus an average since 1970 of 18%.
Enter falling stock prices. The most immediate effect is on capital gains taxes, receipts for which have varied sharply since 1995, from nearly 12% of individual income taxes during the dotcom stock bubble to half that much following the housing crash. Unsurprisingly, the budget surplus from 1998 through 2001 and the deficit reduction from 2004 through 2007 coincided with two periods when capital gains tax receipts were highest. The CBO projects that capital gains tax receipts will rise from $56 billion last year to more than $100 billion a year from 2013 on. If those gains don't materialize, deficits will grow faster than expected, increasing the need for more taxes, spending cuts, or both.
Then there's something called the wealth effect. A rise in asset values leads consumers to spend more, the thinking goes, and because consumer spending is 70% of GDP, it matters greatly for corporate profits, wages and other sources of government revenue. The relationship between stock returns and the wealth effect is the subject of some disagreement; a 2000 survey of prior research published in the Journal of Economic Perspectives found that "the rising stock market has surely contributed to rising consumer spending in the 1990s," but a new working paper whose authors include Karl Case and Robert Shiller, creators of the Case Shiller index for house prices, finds "at best weak evidence of a link between stock market wealth and consumption" and a much stronger link for housing wealth. Whatever the nature and size of the relationship, no one argues that a stock decline would be good for spending or federal revenues.
Here's a curveball: state and local pensions. The average one was 76% funded at the end of 2010, according to a June study by the National Conference on Public Employee Retirement Systems. That's good news, because a funding level of 70% or higher is adequate, according to Fitch Ratings, which judges creditworthiness. There's one problem, however. Funding levels are determined by comparing two things: the value of assets now and the value of investments needed now to pay obligations over coming decades. The first item is easy to calculate. The second is based on an informed guess. States and local governments may be guessing badly in order to flatter their balance sheets.
The average public pension assumes its assets will return 7.7% a year indefinitely. A paper scheduled for publication in the Journal of Finance argues pensions should use Treasury yields instead. (The 10-year yield is now 2.6%. ) That's because pension obligations are near-sacred in terms of states' constitutional requirements to pay them, taking priority over even municipal bonds in most cases. Sure-thing obligations call for math that assumes sure-thing returns, and with the average pension nearly three-quarters invested in risky assets like stocks, high-yield bonds and hedge funds, 7.7% a year isn't a sure thing. If returns average, say, 4% in years to come (I outlined the case for that Tuesday), states could come up short by hundreds of billions of dollars. Some 66% of pension funding comes from portfolio returns now. More of it may have to come from taxes if stocks stall.
Investors can do more than sit and wait. Municipal bonds, tax-deferred retirement accounts and master limited partnerships are among tools that can trim taxes. AA-rated, 10-year munis pay more than Treasurys, even before considering their tax advantages. The contribution limit for 401(k) retirement plans remains $16,500 for 2011, but workers over 50 might be able to make an additional $5,500 "catch-up" contribution, depending on their plan. MLPs include Kinder Morgan Energy Partners (KMP), Enterprise Product Partners (EPD) and Magellan Midstream Partners (MMP). They yield between 5.3% and 6.5%, and a portion of their income can qualify for tax deferral.
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