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Eye on the Market | July 25, 2011
J.P.Morgan

Topics: US debt ceiling negotiations, a more ambitious European bailout plan (finally), and how large cap growth stocks and rising corporate profits are patiently waiting for both of them to end

I have a feeling that revenue increases will be a material (e.g., 25% or more) part of the deal. The Peterson Foundation's sampling of 6 policy groups shown below indicate that 5 of 6 recommend revenue increases compared to where we are today; the Heritage Foundation's "Woody Guthrie Memorial Budget Plan" is the only exception. What kind of revenue increases? Raising the top two brackets, which would affect joint filers with adjusted gross incomes above $212,300, would raise $450-$700 billion over 10 years (depending on whether you use OMB or CBO numbers). If they cannot agree to raise rates, another option (as in the Gang of Six plan) would be reductions in the deductibility of state and local taxes, sales taxes, mortgage interest, etc. As this gets sorted out, let's hope everyone recognizes that the US tax system is already progressive. As shown in the chart below, effective Federal tax rates for low earners have dropped to zero over the last decade, even after including FICA taxes. News reports that the US tax system is regressive make me want to throw hamburgers at the screen.

Revenues and Spending as a % of GDP
Revenues Spending
Fiscal year 2011 15.3% 24.1%
Fiscal years 1950-1969 17.5% 18.1%
Fiscal years 1970-2010 18.0% 20.8%

Estimates for 2035:
CBO alternative case 19.5% 33.9%
American Enterprise 19.9% 22.8%
Bipartisan Policy Center 23.1% 23.7%
Center for Am. Progress 23.8% 23.2%
Economic Policy Institute 24.1% 27.8%
Heritage Foundation 18.5% 17.7%
Roosevelt Institute 22.9% 24.8%
Source: OMB, CBO, Peterson Foundation 2011 Fiscal Summit.

What a progressive income tax system looks like
Combined effective federal income and FICA tax rates
[Chart showing tax rates from 1955 to 2010 for High earners, Median earners, and Low earners]
Source: Tax Policy Center.

Europe: Finally (!!), but now what?
For the first time since 2009, it felt last week like European policymakers were trying to get out in front of things. In exchange for a modest amount of "private sector involvement", Germany agreed to more generous financing terms for Greece, Ireland and Portugal, and an expanded role for the EU-IMF lending facility (see following page). What would the plan accomplish if implemented? While Greek debt to GDP ratios would remain well over 125% of GDP (the IMF estimate for next year is a ridiculous 170%), Greece's near-term financing obligations would decline, due to debt buybacks, exchanges into long maturity bonds, and interest grace periods on new EU loans. More broadly, the plan also allows for money to be lent to countries before they enter into an IMF program, for recapitalization of banks. All things considered, it's the broadest defense of the Monetary Union so far. On paper, it even looks like a free ride for holders of Greek paper that don't participate in the debt exchanges (they would be paid at par). So, what's not to like? Well, there are still questions about Greece:

• There's a big difference between generous financing terms and generous economic terms. Greece must still meet an enormous 5%-6% primary budget surplus target (government revenues less spending, pre-interest) during a recession

• Greece must execute on its asset sale targets, despite having little success or experience doing this in the past

• Banks listed in the IIF document (the committee representing them) are under no binding legal obligation to participate in the debt exchanges, and may turn out to own less Greek debt than currently believed. [Note: bank participation in the Latin Brady bond era was high, since at the time, banks held almost all the paper, and in the form of illiquid loans].

The big question: would Germany still live up to the deal if Greece missed deficit targets or assets sales, if bank participation was too low, or if hedge funds (once referred to by the Chairman of the German Social Democratic Party as a "swarm of locusts") reaped large free rider windfalls? Ultimately, this is a political question. If "yes", Germany will underwrite Greece no matter what; if "no", then a broader, coercive Greek restructuring might follow in the not-so-distant future³.

³ This could get complicated. If there is a need for further debt forgiveness for Greece, will policymakers find a way to "ring-fence" the banks that participated in the first round, and impose losses just on the hold-outs? Will the EU tell banks that if they don't participate, their older bonds will not be eligible for financing at the ECB?

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