Remembering Christina Romer: Tax Increases and Their Economic Impact

Aug.10.10 | About: iPath S&P (VXX)

In June of this year, a little known organization called the American Economic Review published a 39 page research article, titled “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks.” I have quoted from the publication here:

This paper investigates the causes and consequences of changes in the level of taxation in the postwar United States. Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent… and that [capital] investment falls sharply in response to exogenous tax increases.

In other words, for every dollar of additional taxes that the government collects, there is approximately $3 of lost economic output for the U.S. economy. Now, this paper and its conclusions might be relatively unconvincing to many if it had been written by a conservative think tank, or by a biased researcher promoting the pro-Republican agenda of lower taxes. However, nothing could be farther from the truth. In fact, this paper was written by Christina Romer and her husband David Romer. In case the name doesn’t ring a bell, please allow me to remind you that Christina Romer is President Obama’s hand-picked Chair of the Council of Economic Advisors (“CEA”). The CEA’s core function is to provide the President with objective analysis and advice on a broad range of economic matters. The CEA is perhaps the most influential economic team in the country because it directs the economic policy of the White House and the President. Christina Romer herself has said that she speaks with the President almost every day. The full text of Christina Romer’s research can be viewed from her website (here).

Sadly, on Friday, August 6th, Christina Romer announced that she would resign from her position as the Chair of President Obama’s Council of Economic Advisors. Romer’s resignation received far less media coverage than that of HP’s Mark Hurd later that same day, but the former is much more relevant to most investors in the long run. Less than one month from now on September 3rd, Christina Romer will leave her White House position and the CEA to return to private life as an economics professor.

So, let’s review: 2010 is a pivotal election year with the nation also facing a year-end deadline to overhaul its tax code, or else significantly higher tax rates will be in place going forward. The President of the United States has clearly stated his position on the matter and favors a variety of tax increases, particularly on those rich folk who make more than $200,000 per year. Two months ago, Christina Romer, Chair of the President’s Council of Economic Advisors, published a paper that convincingly demonstrates the damaging economic consequences of tax rate increases. Subsequently, Romer has decided to return to private life and will no longer be an economic advisor to the President. Got that?

The Romer development is rather disheartening to those that may have hoped for less aggressive or more thoughtful action with respect to future tax rates. For investors and traders there are two specific consequences that stem from a higher tax rate structure. First, there will be a fair amount of year-end volatility and selling pressure as investors take long-term capital gains at the 15% rate currently in effect for 2010. Longer-term, as Christina Romer’s research suggests, the effects of those tax increases will be very damaging to economic growth, dimming the outlook for equity valuations and the stock market in general. As the research suggests, for every dollar of additional taxes that the government collects, there is approximately $3 of lost economic output for the U.S. economy. Those of us hoping for an extension of the precious tax cuts may have just lost our best ally. Certainly there are others who will continue the fight, but none have the ear of the President everyday, nor the influence that Christina Romer has had for the past two years.

Depending on individual preference and current portfolio positions, investors and traders should prepare for year-end volatility and potential for substantially higher tax rates going forward. A long-only investor might simply reduce overall market exposure or sell stocks with long-term unrealized gains. An option trader might buy S&P 500 put spreads into the January-2010 contract month. Investors and traders that maintain hedged portfolios might remain long quality stocks and short high-beta or cyclical stock ETFs, and so on. Shorting high-beta ETFs linked to commodities, mining stocks, or technology stocks is one way to hedge market risk going into the end of the year. A final alternative is to be “long volatility” through option positions or an ETF such as VXX – the iPath VIX Short Term Futures ETN. But be careful, the VXX (like other ETFs and ETNs that are conduits to the futures markets) should only be used as short-term trading vehicles, not long-term portfolio hedges. This is because such securities will underperform their indices over time due to the process of rolling futures contracts from month to month.

Disclosure: No positions