In the summer of 2015, either one or both political parties will begin the search for their next presidential candidate (depending on whether Mitt Romney wins the election this fall). By that time, the whole tenor of political positions will have sharply changed.
At least, we can only hope so.
That's because our economy is unlikely to handle three more years of gridlock, which keeps us stuck in a phase of higher government spending and shrinking revenue. Any day now, the ever-rising mountain of debt will need to be addressed. In the face of inaction, the bond market will have spoken by 2015 anyway, as "bond vigilantes" force the government to get a grip on the never-ending deficits.
Right now, we have a pretty clear read on the broadly-staked positions of the Democratic Party. Yet signs are emerging that we'll see a bruising battle for the heart and soul of the Republican Party. How it plays out will help shape what the U.S. government looks like in 3-4 years.
In recent weeks, we've seen GOP primary victories by tea party candidates for the Senate in Indiana and Texas. In Texas, tea party darling Ted Cruz defeated Lt. Gov. David Dewhurst by a 4-to-3 margin -- and Dewhurst already had pretty deep conservative bonafides. In Indiana, long-time Sen. Richard Lugar is one of a long line of center-right conservatives that has been shown the door.
Make no mistake, the ascent of the tea party, first in the House of Representatives, and now perhaps in the Senate, will likely set up a pitched intra-party battle in early 2013. Already, signs are emerging that more moderate members of the GOP have hinted at a willingness to compromise with their Democratic counterparts in addressing the coming "fiscal cliff" and longer-term budget repairs. Until now, almost every member of the GOP has voted in line with the party platform. If the tea party strengthens its grip, then don't be surprised to see more moderate GOP members "cross the aisle" on crucial votes.
What it means
If you buy into the logic that our budget deficits will have to be addressed and if you believe that bipartisan compromises will be the only way to achieve that, then we already know how some of this will likely play out.
For example, defense spending is bound to shrink, though not nearly at the draconian rate that the current fiscal cliff scenario envisions. President Obama and GOP nominee Mitt Romney appear committed to increasing defense resources for the Asia/Pacific region, especially in terms of naval strength. By definition, this means a reduction in ground forces elsewhere, and a cutback in other forms of hardware. The Amex Defense Index seems to ignoring this looming change in defense spending.
Fed to states: Not our problem
Early in his term, President Obama sought to help out the 50 states, many of which were facing drastic revenue shortfalls. The salaries of teachers, police officers firefighters were temporarily supported by federal grants -- yet the notion of further support for states has become anathema.
Even as states have started to plug budget gaps through widespread layoffs and slowly rebounding tax receipts, there's more pain on the horizon. Unless we see significant reworkings of public sector labor agreements, especially in the area of health care and pensions, then state-level finances will only worsen with time. In the absence of federal support, the culling of local and state labor forces is bound to continue.
In terms of health care, the recent decision by the Supreme Court to uphold the key tenets of the Affordable Care Act is just a step in the process. Containing total health care spending while expanding coverage is a lofty goal, but many changes are likely to be made along the way until we get it right. This likely means even fewer dollars per patient when it comes to drugs, devices, home care services, hospital stays and other health care items. If you own the stocks of health care companies, then you need to figure out if they will be more useful or less useful in world where every cost comes under pressure. [For my take on this, read this article.]
As this chart shows, Japan spends roughly half as much on healthcare as we do, yet arguably has superior outcomes (in areas like longevity and infant mortality). Though this chart is from 2009, little has changed since.
Sacrosanct deductions: Not anymore
Perhaps the biggest changes to come involve the tax code. Right now, many are focused on the possible extension or elimination of Bush-era tax cuts. It looks increasingly likely that taxes -- at least for the wealthiest Americans -- will be going up, even if Romney wins the election. Conservative economists such as Bruce Bartlett and David Stockman who have worked for past Republican Presidents now concede that prolonging our fiscal crisis by extending tax cuts on top earners starts to become detrimental for the economy, which greatly affects the "investment class."
Yet even a return to the tax rates of the Clinton administration won't simply close out budget gaps -- even if government spending shrinks. That's why a wide range of tax deductions will eventually be on the chopping block. By eliminating deductions, politicians can essentially claim that they didn't raise tax rates.
For example, it's hard to see how deductions for mortgage interest and charitable giving can survive any budget fix. These deductions may get preserved to an extent, but are likely to be trimmed to some degree.
And we're not just talking about individual income taxes. Both parties have taken note of the fact that U.S. companies face some the highest tax rates in the developed world, and a drop in those rates could boost corporate effectiveness. To achieve that, both parties have expressed a willingness to trim tax deductions so that major corporations such as GE (NYSE: GE) no longer get away with an effective tax rate of 10% -- or less. In effect, the stated tax rate for all corporations may go down, but total tax receipts from corporations are likely to go up.
The big new tax that has increasing bipartisan support
With a tax code larded up with deductions, the reality is that many Americans end up paying a lower tax rate than they realize. And although many members of the GOP are loathe to raise taxes, they would like to see a simplified tax code. However, the goal of reducing the overall tax rate to just a few basic categories may still end up expanding our budget mess.
Yet some of these same legislators have suggested a reasonable fix: tax consumption.
By adopting a national sales tax (known as a Value Added Tax or VAT in other countries), the government could raise revenue without hiking income taxes. Using FairTax.org's platform as an example, "every person living in the United States pays a 23% national sales tax on purchases of new goods and services. This rate is equal to the lowest current income tax bracket (15%) combined with employee payroll taxes (7.65%), both of which will be eliminated."
That's a pretty stiff VAT rate -- even higher than what is seen across Europe, and would surely raise the hackles of any consumer-facing business. If we are to get a VAT, then it is likely to be closer to 5%, and other income taxes would stay in place (and not be eliminated as these folks suggest).
Yet the appeal of a VAT is undeniable. Taxpayers would benefit from a less complex tax code, and the ability to cheat on taxes would be reduced.
Grow our way out of it?
Both parties may have been dragging their feet in tackling these tough choices in hopes that economic growth would help save the day. After all, a rising economy in the 1990s helped bolster government tax receipts to the point where a chronic deficit briefly become a surplus. That's unlikely to happen these days for the very simple reason that the budget mess is partially responsible for the uncertain economic environment that is leading to tepid job creation.
Washington can't sit and wait for things to get better. The large budget deficits have been a concern for almost a decade now, and every year, the can has been kicked down the road. Yet it's impossible to see how this can last much longer. That's why we'll be talking about a different set of issues by 2015, when the next election season rolls around. By then, we'll have already been forced to make major changes -- which by definition mean higher taxes and a smaller government. That's a Solomonic solution that few will relish, but is nearly unavoidable.
Action to Take --> The concern isn't simply that taxes will go up for those that already feel over-taxed. Or that the government's support of a wide range of programs will sharply erode. Instead, it's the actual effect of a change in the tax-and-spending dynamic on the economy and stock market.
Though persistent budget deficits have many harmful effects on our future economic competitiveness, they provide a clear boost to the economy and the market in the short term. Think about it... A government that spends more than it takes in is adding liquidity to the economy. In recent years, we're talking about hundreds of billions of dollars of liquidity.
Yet a move to raise taxes and shrink spending does the opposite. It sucks money out of the economy. Of course, eliminating budget deficits simply moves the government into a neutral posture. But our total government debt is so high that this neutral posture may not last. Instead, the government will eventually be forced to reduce our massive debt, which means running a government surplus--which pulls money out of the economy. That was manageable in the late 1990s when the economy was on a robust plane of growth. But today's politicians -- nor the ones who will be pondering a run for the White House in 2015 -- will likely be operating in an environment of robust growth.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.