A Fistful of Dollars

April 19th, 2013

by Eric Schaefer

While many may rue that Christmas comes but once a year, we doubt there are the same ranks who wish the same for April 15th. So, at the stroke of midnight on Monday, April 15th, legions of Americans began breathing a sigh of relief as the annual escapade of filing their income tax returns was over until the same time next year.

There are those though who are apprehensive about what the collected returns will show. We imagine the new Treasury Secretary Jacob ("Jack") Blum is among those wringing their hands in suspense until the last return is tabulated. Why? Because they hope for a windfall of sorts if the taxes collected exceed expectations.

A lot of ink has already been spilled on the link between the stagnant job market and the federal government's reduced take of income and Social Security taxes. Lower employment and slower wage growth translates directly into lower tax revenues. It is easy to understand the reason for this emphasis: in 2010 (the latest year for which aggregate income tax statistics are available), wage and salary income accounted for 72% of the $8.1 Trillion in adjusted gross income (AGI) reported by U.S. households.

What does not get much press is that the $5.8 Trillion in wage and salary income (for 2010) is actually little changed from the amount reported for 2007. We suspect when the statistics for 2011 are tabulated, wage and salary figures will show some (albeit modest) improvement. Until conditions in the labor market improve dramatically, the rebound will be slow and steady.

The real volatility in the government's take comes from fluctuations in passive (or, portfolio) income. In 2007, these elements accounted for just over 17% of AGI. In 2010, in contrast, these same income sources contributed just under 10% of AGI. In absolute amounts, portfolio income in 2010 was just a bit over half of its 2007 totals.

Since the financial meltdown and ensuing recession, each of the five categories registered a declined. Only tax-exempt interest income (from municipal debt) levels did not retreat as much as the other items. The recession battered condition of municipal finances has required cities, counties and states across the nation to issue debt to plug budget deficits; while persistently low interest rates have increased the relative attractiveness of municipal debt's after-tax returns.

Even dividend income has taken a wallop despite the strong balance sheets and cash flows of non-financial corporate America. Lingering concerns among regulators regarding the capital adequacy of money center and regional banks has prevented financial institutions from upping their dividends. A number of prominent (and more not so well known) corporations have not been given approval to return more capital (in the form of higher dividends or more share buy-backs) to their investors.

But it is the depressed volume of realized net capital gains (from all sources) that has kept the lid on portfolio income levels. The $388 Billion in capital gains reported for 2010 — while a significant increase from 2009 levels — was still less than one-half of 2007's high water mark of $838 Billion. With the recent advances in U.S. equity market indices, we expect profits from the sale of capital assets will continue to climb; but, if the past is any guide, we doubt 2007 levels will be matched or exceeded until tax year 2013 at the earliest. After the dot.com bubble of 2001, it took five years (2005) before capital gains income rebounded to pre-crash levels.

When 2012 returns are compiled we anticipate the federal government will have a pleasant surprise. The improvement will certainly not be of a magnitude to completely erase the deficit, but it will make a dent. Every $100 Billion improvement in reported capital gains generates $15 to 25 Billion in tax revenues. Secretary Lew may just find the cushions of tax payers' portfolios yield a fistful of dollars instead of just some loose change.

Notes on Sources and Methods:

All data obtained from the Internal Revenue Service (IRS).

Dividend income includes qualified dividends from 2003 going forward.

Capital gains distribution levels in each year combine capital gains reported on Form 1040 along with those amounts reported on Schedule D of Form 1040.

Net realized capital gains consist of proceeds from a variety of sources. Such income will include gains from security (viz., stock, bond, mutual fund, etc.) sales as well as from the sale of real assets such as homes, rental property, etc. and partnership and business sales. The total combines short- and long-term gains. Amounts reported by the IRS for each year were reduced by capital gain distributions reported on Schedule D. (Sources: IRS; AIFS estimates.)

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About American Independence Financial Services, LLC

American Independence Financial Services, LLC ("AIFS") is the investment adviser and administrator for the American Independence Funds. The firm is a limited liability company founded in 2004. It is majority owned by its senior management, who average over 25 plus years of industry experience and achievement. Today AIFS offers eight different mutual funds and manages approximately $1.1 Billion in assets on behalf of its clients.

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The views expressed in this document are based on political, market, economic and other conditions subject to change at any time. Data are acquired from sources believed to be reliable. But no warranties are made to the accuracy, completeness or timeliness of the data and information presented. Opinions expressed are those of the author unless indicated to the contrary. Nothing in this document should be construed or taken as financial or investment advice. Please consult with your financial advisor to discuss how the subject of this research report may impact your unique, individual circumstances.

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