How to Prepare for "Taxmaggeddon"

Joseph Hogue's picture

Tuesday, October 9, 2012 - 8:30am

by Joseph Hogue

I just finished watching the first presidential debate, and like about 50 million other Americans, I'm left a little disappointed and wanting more details about the candidates' plans. Each candidate talked a good game and promised to turn the struggling economy around, but both disguised the hard realities that are about to set in.

Bond guru Bill Gross recently pointed to a series of studies that showed the United States needs to cut spending or raise taxes by $1.6 trillion per year during the next five to 10 years, or face an inevitable loss in standard of living and global power. 

For perspective... the so-called "fiscal cliff" that is worrying everyone so much and could shave up to 4% off the economic growth next year is only worth about $600 billion, less than half of the cuts that are truly needed.

The fact is that a reduction in debt and a return to economic stability will not come by reducing spending alone. The government will need to raise taxes or eliminate deductions if it wants to meet its fiscal responsibilities. Fortunately, a rational look at possibilities under each candidate can help investors better position their portfolio for the inevitable.

Obama's tax plans
President Barack Obama has made it clear that he will seek to keep income tax rates at present levels for those making less than $250,000 per year, while letting the Bush-era tax cuts expire for the highest brackets. Under the President's second term, taxes on capital gains may return to 20% from the current 15%, while dividends would be taxed at a person's income bracket. 

Increasing the rate on the upper-income brackets would probably not have a direct affect on stocks, though some would contest that a negative effect on the economy would flow through to the market. What is more certain is that dividends may lose their luster since people will have to pay higher tax rates on dividends. Many corporations that pay higher dividends might shift money to share repurchases over dividend payments, basically returning the same amount to shareholders. But it is still likely that a negative sentiment toward classic dividend-paying stocks such as consumer staples and utilities would ensue in the short-term.

President Obama has also promised to reform the corporate tax code, lowering the rate from 35% to 28%, while removing many of the loopholes and deductions. A closer look at the proposal shows a possible net benefit for manufacturing, clean energy and small businesses, while the oil and gas industry would probably end up paying a higher rate overall. With a still-struggling global economy and possibly higher tax rates, investors may want to underweight some of the large-cap energy stocks such as Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX) until more clarity emerges. 

The President is clearly in favor of higher government spending to support the economy. Any attempt to stabilize the deficit means higher tax rates, most probably from corporate America. While the details of any reform package have yet to emerge, two niche businesses will likely outperform in such an environment. 

Corporations that are not taxed at the corporate level, like real estate investment trusts (REITs) and master limited partnerships (MLPs), should benefit from stronger investor sentiment and greater competitiveness as other corporations figure out how to manage their new tax burdens. Among possible winning players in this arena, I like Linn Energy (Nasdaq: LINE), a strong player in the oil and natural gas infrastructure that pays a 7% dividend yield. (Linn isn't a MLP or a corporation per se, but a limited liability company with partnership tax status, which means it's a non-taxable entity.) Health Care REIT Inc. (NYSE: HCN) could also win big from the tax-advantaged status of REITs and from higher hospital visits due to the new health insurance mandate.

Romney's tax plans...
The environment after a Mitt Romney win is more difficult to analyze because the former Massachusetts governor has not released many details about his plan. He contends that the reduction in government revenue from lowering corporate taxes and other tax cuts would be "revenue-neutral." This means that either the economy would need to pick up significantly or Americans would see a higher tax burden implicitly through the loss of many tax deductions that would be ended in order to close the gap. 

The Tax Policy Center, a bipartisan research group, issued a report in August looking at the deductions that would be necessary to meet a $360 billion revenue loss under a revenue-neutral policy. The group found that the government would need to reduce roughly 65% of all available tax deductions including popular benefits such as mortgage interest deduction, the exclusion for employer-provided health insurance, deductions for charitable giving, and benefits for low- and middle-income families like the Earned Income Tax Credit and the child tax credit.

A loss of the mortgage interest deduction would have a one-time effect on the housing sector, possibly hurting shares of homebuilders, as prices adjust to the loss of favored tax status. While momentum in the housing recovery would help to support prices, shares of homebuilders like Pulte Group (NYSE: PHM), for instance, could take a short-term hit on sentiment.

The financial sector would certainly benefit from a Romney presidency. A less onerous implicit tax from regulations like Dodd-Frank, which the governor would almost certainly seek to repeal, would be the main catalysts. The bigger banks like Citigroup (NYSE: C) and Bank of America (NYSE: BAC) could outperform as regulations on capital come down and the ban on proprietary trading is lifted.

Risks to Consider: Trying to position your investments for what politicians may or may not do is a speculative bet. There is always the chance that the government manages to avoid higher taxes in the short-run or that some other event supports stocks facing higher tax burdens. What is not speculation is that higher taxes are coming, and investors need to position the long-term portion of their portfolios.

Action to Take --> Look to tax-advantaged companies such as REITs and MLPs until the fog clears over any new tax reform. then position to own stocks that could win under the different tax code assumptions. The ones I mentioned in this article are good place to start your research.

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Joseph Hogue owns shares of LINE.
StreetAuthority LLC owns shares of LINE in one or more of its “real money” portfolios.