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For years, people have been warning of the perils of the federal debt. Now that it looks like the government may finally be addressing this important issue, many of these same people are now issuing dire warnings of an impending fiscal cliff. Let's take a look at the data to see what actually happens to stocks when taxes go up and spending goes down.

Raising Taxes

Maximum Tax Rate

The first half of the so-called fiscal cliff is rising taxes. When one runs a regression from 1800 to 2011 on the effect the maximum tax rate has on stock returns, here is the result:

Annual Stock returns = 0.0444(x) + 4.19% (with the letter x representing the maximum tax rate).

Let's say the maximum tax rate changes from 35% to 39.6%. That is a difference of 4.6 percentage points. Multiplying 4.6% by 0.0444 equates to 0.20%. This would suggest letting the Bush taxes expire would make stock prices go UP by an additional 0.20% per year.

Maximum income tax rate table

It is puzzling how the overwhelming majority of financial pundits are predicting bad things for stocks if taxes go up. Actually looking at the data can be rather helpful. Do you invest based on what somebody thinks should happen, or go by what has actually happened? While the majority confiscating money from a minority is unjust, such actions should not have an adverse effect on stocks.

Dividend Tax Rate

People are also concerned with the dividend tax rate increase. Richard Shaw has conveniently presented a nice historical table on the dividend tax rate. I have performed a stock market annualized return analysis based on the years of the four major dividend tax rates:

Dividend tax rate table

The results were once again diametrically opposed to prevailing conventional wisdom.

Spending Cuts

If the government does not come to an agreement before the end of the year, supposedly $1,200 billion worth of spending cuts over the course of 10 years will automatically be enacted. That equates to about $120 billion a year. The government spent about $3,728 billion in 2012. So we are talking about roughly 3.2% worth of spending cuts.

According to usgovernmentspending.com, since 1950 the government has actually decreased spending in five years:

Spending cuts table

Instead of "the Fiscal Cliff", perhaps "the Fiscal Rocket" would be a more appropriate moniker.

The current spending as a percentage of GDP for 2012 is 23.58%. The United States has had 80 years where it did not increase the federal debt. Of those 80 years, 75 of them had spending as a percentage of GDP of 7.68% and below. The other five (1947, 1948, 1951, 1956 and 1957) ranged from 13.23% to 17.74%. The maximum tax rate for those five "outlier" years ranged from 82.13% to 91%.

So any time spending has been more 17.74% of GDP, the federal debt has always gone up. Even with 91% tax rates. The people who think we can "tax the rich" to get out of debt without epic spending cuts are wrong. In order to not add to the debt (even with 91% tax rates), we are still going to have to reduce spending by 24.7% (from 23.58% of GDP to 17.74%).

The current revenue as a percentage of GDP is 16.6%. If spending is reduced to reach the current revenue level ,it must go from 23.58% to 16.6% ,which is a 29.6% decrease in spending.

Of the aforementioned 80 years where the United States did not add to the debt, 75 of those years had revenues as a percentage of GDP from 1.2% to 8.4%. The five "outlier" years discussed earlier had ranges from 16.7% to 18.9%. . The United States has had 15 years where revenues were MORE than 18.9% a year. Interestingly enough, despite the revenue windfall, all 15 years the United States actually added to the debt.

In summary, the United States should keep the revenues as a percentage of GDP at less than 18.91% a year and reduce spending as a percentage of GDP to below 17.75% a year.

As for equities, ignore the fiscal cliff myth and ride the fiscal rocket.

This article by James Debevec originally published on Minyanville.

Below, find some more great content from Minyanville:

Twitter: @minyanville

Disclaimer: The views represented on this blog are those of the individual authors only, and do not necessarily represent the views of Schaeffer's Investment Research.


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