Two Investment Strategies for The Payroll Tax-Cut

How should you invest to profit from the one-year cut in payroll taxes that are promised in the tax compromise deal cut this week between Obama and Republican lawmakers?

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The answer depends on what you think will happen to the extra-income people receive from the payroll tax cut. It’s not a lot of money: the benefit tops out at $2,100 per year for workers making $106,800 or more. But the Obama administration has high hopes that it will stimulate more consumer spending—which could create investment opportunities.

There’s a lot of controversy over whether the Obama administration’s theory of the payroll tax cut is right. The Obama administration believes that people are more likely to spend more if the tax cut is dribbled out little by little, paycheck by paycheck. They look at the Bush-era tax rebates—which came as one large check—as a failure, in part because they didn’t stimulate spending as much as hoped.

But at least one academic study indicates that the Obama administration’s plan might be even worse. Instead of spending more, people might spend less of the additional income when they get it incrementally.

In either case—there’s a lot of evidence to suggest people won’t spend very much more regardless of how they get their checks. Because the additional income is only temporary, spending habits might not be changed much. In fact, people might save most of the additional income because they know that when the payroll tax holiday is over, they’re income will shrink again.

If you side with the Obama administration, you might want to look into investing in retail that can benefit from a small hike in the regular spending by consumers. This probably means groceries and clothing, rather than big ticket items. (Conversely, if this tax holiday is changed into a one time rebate, people will probably buy iPads and dish-washers.) Credit card companies may also benefit from this increase in regular spending.

If you take the position that the payroll tax hike will be used for savings or deleveraging, the situation is more complicated. It may be that the tax-cut will keep some homeowners who are near the point of defaulting in their homes. So expect some marginal improvement in the default rates from what they would have been otherwise. This could help the bottom lines of banks heavily exposed to housing—although, again, there are enough hazards in the banking sector that you might want to be cautious here.

Probably a better bet is in low-cost asset managers and brokerages. If savings rates rise, companies that run low cost money-market funds and other savings alternatives, should be major beneficiaries. Charles Schwab might be a good choice here.

So who is right? I’ve explained elsewhere why I think the Obama administration’s view of the stimulus value of the payroll tax cut is mistaken. If I’m right, however, I won’t have much to show for it. I’m exclusively invested in mutual funds that cover broad market sectors. So I’m afraid I cannot say I’ve put my money where my mouth—or my blogging—is.


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