Watching Sausage Being Made: The $3.5 Trillion Budget Reconciliation Package

Otto Von Bismarck, the man credited with uniting various fiefdoms into what is today Germany, once said there are two things the public must never see: one is sausage being made; the other is how legislation is passed into law.

The $3.5 trillion reconciliation spending bill before Congress this week is already known for its size and breadth of recipients.  Programs as diverse as building veterans hospitals and providing hearing aids and dental care for seniors are on the agenda. Interestedly, the American Dental Association is against the proposal since Medicare pays relatively little.  Community colleges would become free to all who attend, while pre-school programs accommodating students as young as three and four years old would be offered, assuming matching state funds. 

A program of this size will require significant funding.  While the plans are not yet finalized, below is a partial list of what to possibly expect.

There is a pledge not to raise taxes on individuals making less than $400,000 per year or families earning less than $450,000.  Above that level, things get interesting.

Incomes in excess of those amounts would see the marginal tax rate increase to 39.6% from the current 37%.  Families or individuals making over $5 million per year will be subject to an additional 3% surtax on the excess.

The top corporate tax rate will be increased to 26.5% from 21% for companies making over $5 million under the proposal.  The top capital gains tax rate for individuals goes to 25% from 20%.

There is a provision for taxing net investment income in excess of $400,000 ($500,000 joint).  This pertains to hedge fund operators, private equity organizers, and the like.  Previously they have used various tax avoidance strategies to pay no more than 15 percent tax on their investment income. 

All these increases are to bring in a net $1 Trillion per year.  Add increasing the budget for IRS enforcement, taxing foreign earnings at 16.5% (up from the current 10.5%), and additional levies on those earning more than $5 million per year, and the estimated total income is $2.9 Trillion.  After estimating that the increase in economic activity will kick in another $600 Billion, the $3.5 Trillion funding package is financed.

Two caveats:  the package has not been voted on, so anything can happen, both on the spending and tax side.  Second, getting spending of this magnitude off the ground will take more than a year.  It may take more than two.  Given the tightness of the current labor market, the programs will be collectively quite inflationary. It could be that the biggest impact on the economy will not be the taxes themselves but the competition for workers. 

2022 was previously shaping up to be a year of decelerating revenues and higher input costs.  In other words, narrower profit margins.  Higher corporate income taxes will have an adverse effect on corporate profits, perhaps causing what was projected to be flat aggregate earnings year over year to go negative. If this is the case, companies will have even more incentive to raise prices sooner rather than later, and the Fed’s mantra about “transitory inflation” will go out the window.

Most of the discussion thus far has less to do with the merits of the various proposed programs and more to do with whether we as a country can afford it.  There may be some pushback on parts of the tax proposals due to their costs.   

Republicans would like to see the measure fail so as not to give the Democrats credit for the enactment.  They would also like to avoid the tax increases, which even some moderate Democrats see as a bit much.

We will have to wait to see what happens.  In the meantime, talk of victory or defeat here is more one of the percentages.  Probably neither side will get all it wants.  The trick will be to see how much is signed into law and how it is financed.

The Economy

Economic activity is moderating. A combination of higher labor costs and transportation expenses has made advancing revenues and profits problematic.  An effort afoot to create more output in the US has run into problems of finding domestic expertise for products that have been almost exclusively imported for years. 

The pending spending package will greatly increase the demand for labor. Whether it will provide a second wind to the economy could depend on how, for example, increasing funds for child care frees up women to re-enter the workforce in greater numbers than previously.


Inflation is rising.  Import disruption, semiconductor chip shortages, and changing demographics are all working to push prices higher.  The party line at the Fed has been that the increase in prices is transitory, although no forecast sees a decline in labor costs this year or next.

The Fed has not incorporated the spending bill before Congress on the rationale that it is not foreseeable until passed.  Look for forecast revisions once the dust settles on the size and shape of the spending packed adopted.

Interest Rates

Every time the Fed meets, the date for increasing interest rates seems to be pushed forward.  Three months ago, it was 2023.  Now it is early 2022.  Depending on the size of the spending bill to be passed this week, it may be late 2021.

There is a school of thought that the stock market cannot afford an interest rate increase given its rich valuation.  While that may be true of some of the more generously valued shares, it does not appear to be true of the market overall. 

The Stock Market

Stocks overall seem to be a bit rich in terms of price.  Possible downward revisions in earnings estimates, a lack of clarity on what is going on in China, and the lingering effects of COVID have all made the estimation of revenues and profits for next year and beyond especially fraught.  Some retailers are talking of selling out their holiday inventory in November due to supply-chain complications.  They frankly cannot predict how and when they can stock their shelves for Christmas.

Some industries are doing better than others.  Energy seems to be a bright spot for those who will still invest in the same.  Financial firms as a group are expected to benefit as interest rates rise.  Freight transportation is booming, passenger transportation less so. 

The fourth calendar quarter is usually when research firms turn the page and focus on the subsequent year, in this case, 2022.  It will be interesting to see how estimates come out given all the cross-currents at the moment.

Warren M. Barnett, CFA

September 28, 2021

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