Stocks and Tax Receipts

July 1, 2018

by Steve Stofka

There is a close correlation (see end) between the trend in equity prices and Federal tax receipts, as we can see in the chart below. Occasionally, the market gets too optimistic or pessimistic. When it does it inevitably corrects back to the trend in tax collections.


Note the strong divergence between stock prices (blue line) and tax collections (red line) since the 2016 election. Tax collections grew modestly in the first year of the Trump administration; from $2.133 trillion in the first quarter of 2017 to $2.178 trillion in the fourth quarter of last year. Following the tax cuts passed at the end of last year, tax revenues in the first quarter of 2018 fell $150 billion to $2.033 trillion. In fifteen months, the trend is negative for tax collections. In that same time frame, the SP500 rose 20% on the hope – or for some, the faith – that Trump policy will spur economic activity. That greater growth should lead to greater tax collections. It hasn’t.

Some say that the taxes during the previous administrations were too high. “Lowering the rates will raise the revenue,” is the prayer of supply-siders and tax cutters. “Just wait, revenues will rise as strong economic growth kicks in,” they promise. But this correlation of equity prices and tax revenues transcends administrations: the Obama years, and the Bush years and the Clinton years and into the H.W. Bush presidency. We could go even further back. When equity prices mis-estimate future growth, they correct back to the hard trend of tax revenues. It doesn’t happen overnight. The market had been correcting for more than a year before September ‘s implosion of Lehman Brothers in 2008.

George Soros became one of the most successful traders by constructing a story in advance of his trades. The story is a prediction of what he thinks will result if event A happens. When event A doesn’t happen within a set time, or when event A does not lead to B result, he gets out of the trade. He doesn’t fall in love with his story as so many of us do. Economists and politicians fall in love with their theories and stories the way fans do a baseball or football team. This year we’re going to go all the way!

For the long-term investor, the important thing is an allocation commensurate with one’s risk tolerance, time horizon and income needs. Secondly, have patience.


Since 1990, the correlation is .96. Since 1997, it is .91. Since 2008, it is .94. Since the 2016 election, it is -.45.

The Political Battle

October 16, 2016

State and local governments provide the infrastructure of our daily lives, from the streets we drive on to the legal and judicial institutions that maintain a sense of order within our communities, yet we pay far more of our paychecks to a distant capital in Washington.  Why?  To understand we must look at a two century long battle of  opposing ideas, two ideological forces fighting for power.

We can judge the pervasive impact of state and local government by the amount of taxes that they collect to provide that infrastructure.  I’ll count the primary taxes –  sales, corporate and peronal income and property tax.  In the past four quarters, state and local governments collected $1.2 trillion, about 6.5% of the nation’s GDP.

On the other hand, Washington has a much reduced impact in our lives and, we might hope, an accordingly smaller tax bite.  Unfortunately, that is not the case.  In the past four quarters, the Federal Government collected almost three times the state and local amount, close to $3.6 trillion. (Chart link).  For the past eighty years, the Federal Government has assumed an ever larger role as a national insurance company. In the past year, the Federal Government collected $1.2 trillion – the same amount as primary state and local government taxes – in pension and medical insurance receipts alone. (Graph link)

The two major political parties in this country have different ideological approaches.  Democrats prefer to have the bulk of tax collections come into a central authority like the Federal Government, where a number of central committees decide on the allocation of those funds.  Republicans favor a system where the majority of tax collections come into the states.  Decisions over the allocation of those tax funds should be more responsive to the voters in that state.
In the Democratic system representatives from each state in both the Congress and Senate must vie with each other for access to tax funds under an ever growing number of programs that the Federal Government oversees.  States are administrative and geographical branches of the Federal Government and have limited autonomy. In the House, this competition exists within a system of seniority so that junior members must compete for favors from senior members who control committee assignments and access to discretionary funds.

The Republican system recognizes state borders and autonomy to a greater degree that promotes competition among states for the hearts, minds and pocketbooks of businesses and individuals.  Within each state, elected members of both parties should compete with each other for tax funds.  Because each state must adhere to a balanced budget by law, spending has more constraints than the Democratic system.

The responsibilities and powers of the Federal Government are more constrained under the Republican system.  When Article 1, Section 8 of the Constitution gives Congress the power to provide for the “general Welfare of the United States,” Republican politicians and conservative justices read the clause literally, that this provision applies to the states, not the people in the states.

Democratic politicians and liberal justices interpret the clause as meaning that the Federal Government has a direct responsibility for the welfare of each citizen within each state and gives the Federal government greater oversight of state and local communities, which are more easily influenced by local economic interests and disciminations. These two competing interpretations were hotly debated at the drafting and ratification of the Constitution so it is likely that the argument may never be resolved as long as this country exists.

Again let’s come back to that pot of money that makes our cities and counties go.  In the current system we take that same amount and give it to the Federal Government, which spends most of it on older people.  This massive transfer of resources from younger generations to an older generation is likely to permanently hobble our economic growth. Under a broader scope of social insurance programs, the people in European nations have reluctantly accepted the tradeoff of economic growth for increased sense of security in their personal lives – more health, job, educational and child rearing protections.  French people have become accustomed to a 10 – 12% unemployment rate.  In the U.S. such a high rate provokes political upheaval.

Do Americans want to follow the European model?  Half of the citizens of this country say yes, half say no.  What we do know from the European and Japanese models is that, as social insurance programs get larger, the transfer of money from the productive element of society to the less productive segment of society hampers growth.  This in turn makes it more difficult to fund those  insurance programs. There is a tried and true maxim that applies here – what can’t last forever, won’t.

Older Americans should understand that there is no social contract other than the informal contract of the ballot box.  Each generation pays into “the system” and waits until it is their time to collect.  Each generation relies on earlier generations to honor the promise but, just in case, the older generations vote far more than younger generations because they want to insure that pension (Social Security) and health (Medicare) benefit laws are protected.

Insurance companies must keep assets in order to pay future claims.  The Federal Government is not an insurance company and keeps no assets to pay future benefits.  Instead, it collects taxes under the Social Security system and puts those funds in the general pot of money, leaving a little slip of paper in the Social Security fund that says “We owe you.”  Really, it is little more than this – an accounting entry. From that big pot of money, benefits are paid.  This is a cash based system called “Pay Go” or “Pay As You Go.”  The lack of an asset base for future benefits means that it is extremely difficult to convert the current system to another type.  Former President George Bush learned this harsh lesson ten years ago when his political talk of privatizing Social Security ran into the harsh realities of actually making the transition. Oops.  Bush dropped the idea.

This election season is another episode in a continuing series, a battle between the forces who want the Federal Government to take an ever greater role in our individual lives, and those who want to roll back national control in favor of state, local and private solutions.  The election will take place shortly before the debut of the next Star Wars movie.  Some Republican voters see the Democratic vision of the political system as the Empire of rigid Federal oversight and conformity, where everyone must come under the authority of a central command.  Some Democratic voters may see themselves as part of the Rebel Alliance, fighters for the vision of the Old Republic, a constitutional democracy of worlds that is similar to the European Union, and, like the EU, was bogged down in bureaucracy.

On November 8th, 130 million people will unsheath their political swords and continue the battle. (Presidential election stats  Starting December 15th, more than 80 million people will fire up their light sabres at the coming Start Wars movie. (Star Wars box office stats).  En garde!

Four Foundations

Over the next two months, there will be much debate over spending cuts as the debt limit ceiling approaches in late February.  For the past four years, the Federal Government has been running $1 trillion annual deficits.

Deficits are the annual shortfall; debt is the cumulative amount of those annual deficits.  The total debt of the Federal Government, including money owed to the Social Security trust funds, is over $16 trillion, and is now more than the annual GDP, the sum of all economic activity in the country.

Republicans contend that the real problem with the budget is entitlement spending: Medicare, Social Security and Medicaid are the largest programs.  In the past ten years, spending on these three programs has almost doubled and now consumes 47% of the total Federal spending budget.

Spending increases on these programs will escalate now that the first wave of the Boomer generation has reached retirement age.  Too many rigid ideologues in the Democratic Party defiantly defend every penny of this spending.

On the other hand, defense spending is near WW2 levels.  On an annual basis, the current $700 billion we spend on defense is far less than the inflation adjusted levels of $1 trillion we spent at the height of WW2.

Wars may be won or lost at their peaks but the spending occurs over several years.  When we look at a moving five year average of defense spending, we are near the average of WW2.

Judging by the amount of money we are spending, we are fighting the third World War.  Yes, it’s a dangerous world but is it as dangerous as the state of the world during WW2?  Has Al-Qaeda, a loose coalition of stateless forces, subjugated Europe as Hitler’s armies did?  Is the threat of Iran comparable to the domination of Japan over the eastern seaboard of Asia during WW2? 

In the late 50s, President and former General Eisenhower warned that the military industrial complex would invade the halls of Washington.  Preparedness is prudence, but Eisenhower knew firsthand that the industry peddles a self-serving culture of fear to those in Washington.  As high military spending becomes entrenched in the federal budget, regions of the country become dependent on the defense industry; those people send  politiicans to Washington to vote for more military spending and the spending cycle spirals upwards.

Each year, we are spending about $250 billion more than the 70 year average of military spending.  Unlike the spike of WW2 spending, the recent five year average has surged upwards like a wave – a wave that is drowning this country in debt.  As troubling as this is, we must remember that we are running $1 trillion deficits – four times the excess amount of military spending.  Those who say that we can balance the budget by cutting defense spending simply have not looked closely at the data.  We can not balance the budget by cutting only entitlement spending or only defense spending.  Even when we combine the two, we still can not balance the budget.

Which brings us to receipts, a gentle euphemism for taxes.  Economic bubbles inflate the amount of tax revenue to the government but the resulting lack of revenues after the bubble bursts outweighs the increased revenue while the bubble was building.

When we run a projection of revenues using more sustainable averages based on longer term trends, we come up with an optimized $3 trillion in revenues for the current year, still leaving us $600 billion short of current spending. 

The solution then is a mix of four factors: more revenue from 1) economic growth and 2) tax reform; less spending for both 3) defense and the 4) social safety net.  These are not easy choices, particularly when partisans vigorously defend a particular program as though it were the last stand at the Alamo.