Valliere: A Dramatic Shift—Tax Cuts for Everyone?

With the economy softening and Democrats terrified to be associated with tax hikes, the ground is shifting in Washington on the most important policy issue of the second half – whether the Bush tax cuts should be extended.

It may be premature to make a definitive call, but it appears there are three significant new developments:

1. The Bush tax cuts will almost certainly be extended – probably for two years – for individuals making less than $200,000 and families that earn under $250,000. This accounts for the vast majority of Americans, close to 98% according to some estimates.

2. There’s a growing chance – above 50% — that the Bush tax cuts will be extended for everyone. Affluent Americans account for a far larger share of consumer spending than their proportion in the population, as former Fed Gov. Lyle Gramley pointed out in a PRG report earlier this week. A tax hike on these people surely would slow economic growth, so it’s becoming clear that for policy reasons – and, surely, for political reasons – the tax cuts may have to be extended for all Americans.

3. Third and perhaps most importantly for the markets, if the consensus on cutting taxes for everyone begins to gel in the next few weeks, a sense of certainty on taxes may become clear earlier than we thought. It still may be December before the Bush tax cut issue is resolved, but a growing consensus by fall that the cuts will be extended for everyone could become a significant plus for the stock market.

We feel very confident about the first point above, but we’ll offer a few caveats for the second two points.

First, there are plenty of deficit hawks who don’t want the Bush tax cuts extended for anyone; they include former Fed Chairman Alan Greenspan. Second, there are plenty of activist Democrats who will never drop their opposition to “tax cuts for the rich,” and they will become increasingly agitated if it appears the cuts will be extended for everyone. Third, legislation extending tax cuts for everyone could get bogged down; issues such as fixing the estate tax could eat up time in a lame duck session. And most important, an extension of tax cuts for everyone could face a veto threat.

But Democrats are acutely aware of shifts in public opinion. Voters now hate spending, irrationally deeming TARP to be a failure and opposing virtually all new outlays. Despite their sometimes radical views, the Tea Party has had a major impact on national attitudes, which are decidedly anti-government, anti-spending, and anti-taxes. Governors like Chris Christie in New Jersey have embraced that view, and have maintained high job approval ratings.

So it’s not surprising to see cracks developing among the Democrats, who once ranted against the Bush tax cuts. In the Senate, three Democrats have come out in favor of extending the Bush tax cuts for everyone – Sens. Ben Nelson of Nebraska (not a surprise), Evan Bayh of Indiana (a mild surprise because he doesn’t have to run for re-election), and Kent Conrad of North Dakota (a genuine surprise because of his strident anti-deficit rhetoric).

After years of warning apocalyptically about deficits, Conrad surely must realize that in the short run deficits have virtually no impact on interest rates. He and other Democrats would emphasize that the extension must be temporary, probably for no more than two years, and even a one-year extension can’t be ruled out. But a very short extension could greatly lessen any positive impact on consumer attitudes and spending, former Fed Gov. Gramley warns.

And that raises a key issue: extending the Bush tax cuts for everyone obviously isn’t like a fresh tax cut. It simply means that some very negative developments for the economy would be delayed – the top individual rate would not rise from 35% to 39.6%, the top rate for capital gains wouldn’t rise from 15% to 20%, the top dividend rate wouldn’t rise from 15% to 39.6%, etc.

But for investors, who were bracing for huge economic uncertainty this fall, then a potentially major tax hike on Jan. 1, this sudden shift of political attitudes is potentially quite bullish. Again, we still worry that final resolution may not come until December in a lame duck session, but the new consensus quite clearly is that any kind of tax hike could damage the economy next year – and that attitude shift is a significant plus for the stock market.

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Greg Valliere is Chief Political Strategist at the Potomac Research Group, a Washington-based firm that advises institutional investors on how government policies affect the markets. Greg has covered Washington for over 30 years, starting his career as an intern at The Washington Post, then co-founding The Washington Forum in 1974 to bridge Wall Street and Washington. He has held several positions, including Director of Research, for Washington-based firms, including the Schwab Washington Research Group. Greg is an exclusive commentator for CNBC-TV, where he appears regularly on most of the network’s programs.