Insight Line—November 19, 2007

As the race for the White House in 2008 shifts into overdrive, so too are investor concerns over the scheduled 2011 expiration of the favorable tax treatments on dividends and capital gains. And despite campaign rhetoric to the contrary, history suggests tax increases—in one form or another—are on the way. However, they may have a lesser effect on investment returns than current concerns suggest.

Writing from the University of California at Berkley, economists Christina D. Romer and David H. Romer undertake an anecdotal overview of major post-World War II tax cuts from 1945 through 2006 in an effort to discern whether major tax reductions are indeed an effective way to stem the growth of government spending.¹ They conclude, to no one’s surprise, “The results provide no evidence of a starve the beast effect: following long-run government tax cuts, government spending does not fall.”² In other words, tax cuts have little effect on the spending patterns of Congress and the sitting presidential administration. In fact, the researchers argue that, if anything, Congress and/or the administration ultimately uses the tax cuts themselves as reason for implementing future tax increases as a measure to restore fiscal discipline.

Nevertheless, as bleak an assessment of past and possibly future fiscal policy as this appears, the Romers do uncover, I believe, some aspects to tax reductions and subsequent increases worth noting. As I see it, the Romers clearly establish that historical data is indeed supportive of the supply side economic theory contending that tax cuts are, economically speaking, expansionary and as such do pay for themselves—if only in the short-run. However, the victory celebration is but one dance, as all discernable effects on revenue seem to fade after two years. In essence, allowing the tax cuts to expire is a revenue neutral event to the U.S. coffers.

I believe such a conclusion, when taken to its logical endpoint, argues that the positive economic effect on investment returns from the Jobs and Growth Tax Relief and Reconciliation Act of 2003 (which was favorable to dividends and capital gains) has all but faded from the investment landscape. After all, it is the increased economic activity set in motion by the tax cuts that in turn generates higher corporate profits and by connection higher equity prices. I find it a stretch to argue the 60-odd percent gain in the major stock averages since May 2003 (the tax legislation’s inception) is solely attributable to reduced tax rates on capital gains and dividends. In other words, as the political season approaches and tax rate concerns intensify, if history is to be any guide, investors are likely stressing over a non-issue with respect to potential investment returns.

¹ Romer, Christina D. and David H. Romer, “Do Tax Cuts Starve the Beast? The Effect of Tax Changes on Government Spending,” University of California at Berkley, National Bureau of Economic Research, Working Paper 13548, October 2007. Available at http://www.nber.org/papers/w13548

² Ibid, Romer and Romer, page 44

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 11/16/07

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

The release of October 2007’s employment data offered a mixed picture on the health of the economy. Granted while a payroll employment increase of 166,000 to 138.421 million was larger than forecast, an unexpected drop of 241,000 in the labor force along with a 250,000 drop in the household measure kept the unemployment rate from rising above unchanged at 4.7 percent. That said, the weekly unemployment claims data, in conjunction with anecdotal private business hiring expectation surveys, argue anticipating any meaningful drop in the unemployment rate going into 2008 is fraught with pitfalls. Nevertheless, as total employment remains just shy of record levels, I suggest the appropriate action on the table is to circle Up.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up

Down

September 2007 personal income data reassured that the weaker showing in the August data was not the start of a trend. The 0.4 percent increase moves the annualized total over $11.8 trillion. Wage and salary totals of $6.5 trillion are again at record levels. The year-over-year growth rates remain well in excess of those witnessed prior to economic contractions. As such, I suggest any talk of economic recession remains speculative chatter. Please circle Up on the table.

Retail Sales
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

October 2007 retail sales data, though respectable, confirmed the suspected affects of weather and energy. The monthly total of $380.2 billion was stronger than forecast in large part because of higher prices at the gasoline pump offset lackluster department store sales. However, the year-over-year growth trend remains markedly lower than those recorded over the previous two years. As such, I expect downbeat forecasts for the upcoming holiday sales to increase in frequency. Therefore, I continue to suggest the appropriate circle on the chart remains Down.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

Durable goods orders for September 2007, on the back of a surge in transportation orders, showed a strong 0.2 percent increase. Looks, however, can be deceiving. Though measures on inventory build and unfilled orders suggest strong upward revisions to the third quarter gross domestic product (GDP) report, the all-important shipments data sounded a cautionary note. Shipments, a key component to GDP growth calculations, were down 2.1 percent and are now down three of the last four months. This trend, if confirmed in the subsequent releases, suggests a dramatic falloff in domestic economic activity. Therefore, I am leaving Down as the preferred circle of choice.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

Inflationary pressures remain evident but not elevated. The Federal Reserve’s preferred measure, Personal Consumption Expenditures ex-food and energy price changes, as of September 2007 remained at 1.8 percent year-over-year. Despite concerns voiced by some members of the Federal Open Market Committee (FOMC), September’s report marks the fourth consecutive month of inflation remaining within the FOMC’s preferred range of 1 to 2 percent. Therefore, I suggest the appropriate action is to move the circle from High to Low on the chart.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

Despite no formally approved fiscal 2008 budget, the federal government continued to be an economic force in the month of October. As expected, deficit spending continues to be the order as the first month of the fiscal year recorded a $55.6 billion shortfall. The year-over-year budget deficit rose slightly to 1.2 percent of GDP. All expectations are for the fiscal 2008 federal budget red ink to match the $163 billion recorded in fiscal 2007. As such, the federal government continues to stimulate economic activity with deficit expenditures thereby making the appropriate circle on the chart $In.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The FOMC reduced the overnight lending rate to 4.50 percent on October 31, 2007. Market participants were quick to assume the FOMC’s confirmation of balanced risks to inflation and growth argued for no further rate reductions in 2008. However, subsequent events in the nation’s financial system challenge such a conclusion. As stated last month, I continue to position a high likelihood of an additional rate reduction following the December 11, 2007 FOMC meeting. Therefore, please continue to circle $In.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The difference between the three-month Treasury bill yield and the 10-year Treasury note yield was 84 basis points on November 16, 2007. If history is to be any guide, the steepening of the yield curve suggests fixed income investors are not expecting a recession in the coming 12-month period. Please circle Positive.

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

The nation’s GDP in the third quarter, reported at 3.8 percent, appears poised for an upward revision to approximately 5 percent. Stronger than forecast exports, reduced inflationary calculations and a surge in inventory build-up combine to potentially push the growth rate to the highest annualized quarter-over-quarter rate since the third quarter of 2003. With that said, the year-over-year trend of 2.6 percent continues to argue for less than trend growth of 3.2 percent (year-over-year) in 2007. Therefore, I continue positioning the appropriate circle as Below.