"Kee Points" with Jim Kee, Ph.D.

The Bureau of Economic Analysis (BEA) released the “advance” estimate for GDP growth for the first quarter of 2017, and it came in at an annualized rate of .7%. The Atlanta Fed’s GDPNow model had expected .5% at the time (now down to .2%), so the low number wasn’t out of the blue. First quarter GDP growth has averaged about 1% during this expansion (which began in 2009), while second quarter GDP growth has averaged over 2%. There have been two negative first quarter numbers since the expansion began. Markets still seem pretty optimistic going forward, probably because confidence remains strong for meaningful tax reform, and also because Congressional leaders reached a deal on Sunday to fund the government through September 20, averting a government shutdown (formal votes on the bi-partisan deal will take place this week).


Tax reform preview: Gary Cohn, President Trump’s Chief Economic Advisor, and Treasury Secretary Steven Mnuchin outlined the President’s intentions for tax reform in a press conference last Wednesday. The expressed goal was to have a bill passed by the end of the year, so the press conference just hit the highlights and avoided specifics, like budget impacts. The proposal included reducing the number of individual tax brackets to three, with rates of 10%, 25%, and 35% and repealing the 2.8% net investment income or “Obamacare” tax. Also to be eliminated is the alternative minimum tax and estate tax, as well as all tax deductions outside of the mortgage interest deduction and charitable donations. Obviously the impact on government revenues will depend upon how many individuals fall within each of the three brackets, but the income thresholds for those brackets have not been established. The corporate tax rate would be cut to 15%, and that would include small business owners (“pass through entities” such as limited liability companies and S corporations).


Tax rates impact economic activity in four ways. They affect (1) the amount or volume of economic activity, (2) the timing of economic activity (now versus later, or “phase-in” effects), (3) the location of economic activity (both between countries and within countries) and the (4) composition of economic activity, or the sectoral impact (e.g. healthcare, energy, etc. – Laffer Associates). These impacts in-turn are affected by (a) the magnitude of the cuts and the level of rates prior to the cuts, (b) the permanence of the cuts (“sunset” provisions weaken the impact), and (c) the clarity of the cuts (not always obvious given the fog of deductions, thresholds, etc.). The efficacy of tax rate changes have been both understated and overstated by economists of one stripe or another, particularly in the popular press. In fact, I have never heard a really decent (from an economist’s perspective) discussion of tax policies in the popular press (mostly slogans and dogma), and I been following it pretty closely for decades. My attempt would start with the following, taken from an earlier (2009) version of Kee Points (it was “Monday Smart Points” then): About 30 years ago there raged a debate among academics and policy makers regarding the economic effects of tax cuts. On one side were those who advocated tax cuts because they increased spending (aggregate demand) by leaving people more money in their pockets to spend. This group was big on things like tax rebates.


The other group, named ‘supply-siders’ by the late journalist Jude Wanniski, argued that spending in the aggregate remained roughly the same, at least initially; More private spending was offset by less government spending. If government continued to spend by borrowing, then private sector purchases of government bonds would take the place of private sector expenditures on goods and services. This group argued that tax cuts lead to increased output and employment by increasing the relative attractiveness of work versus leisure, savings and investment over consumption, and high risk/reward activities versus low risk/reward activities. They argued that increases in spending or ‘aggregate demand’ and hence economic output were a secondary effect, the result of increased efforts to work, save and invest. Tax rebates, then, were basically just taking money out of one pocket and putting it into another. Norman Ture, a primary architect of both the Kennedy and Reagan tax cuts, put it like this:


“The basic analytical framework of supply-side economics specifies that the initial effects of tax and spending changes take the form of changes in the relative costs and prices people face. The way people respond to these changes in relative prices is likely to result in changing the amount of work and saving and investing, therefore in the amount of output and income produced…But these changes take time. Economic adjustments are not completed instantaneously, even though they are likely to get under way very promptly.”


Ture often stated this in professional economists’ terms as, “The first order incidence of price or excise effects over income effects.” My view is that under times of crisis (like 9/11 and the 2008 global financial crisis), government spending and deficit spending puts a floor under possible economic collapse and helps maintain some confidence and economic activity ( a first order income effect). Under more normal times, however, it is the relative price affects, alluded to above, that determine aggregate economic activity (first order price or excise effects). I’ll talk more about tax specifics when they become available.


Diversification and energy: Rumor has it that Nobel Laureate Harry Markowitz once asserted that diversification was the only free lunch in investing. The point of diversification is that you can add assets to your portfolio and lower the overall risk without lowering the overall return, or, stated differently, achieve a higher overall return for a given level of risk (risk as measured by variance or standard deviation). But not just any assets, they have to have relatively low correlations with one another – and (importantly!) – they must each go up over time. That last part is important; for example, you’re Las Vegas winnings might not be correlated with the stock market, making them a possible diversification candidate, but they don’t go up over time (at least the expected value is negative or favors the house). That rules them out as a good diversification tool.


In an interesting study, University of Chicago law school professor Daniel Fischel looked at the correlation of stocks from each of the (then) 10 broad economic sectors (Healthcare, Technology, etc.) with the overall market. For example, Fischel would construct a portfolio of Utilities stocks, and a portfolio of all non-utilities stocks, and measure the correlation between the two. The more correlated an asset class is to the overall market, that is, the more closely it moves with the overall market, the less useful it is as a diversification tool. What made Fischel’s study unique is that he went back 50 years – rare for a sector study. What he found was that the sector that was least correlated to all of the other sectors was energy. Put another way, investors with a high concentration of energy stocks or energy exposure have the most to gain from diversification.