We’ve heard repeatedly that the Canadian banks are safer than their American counterparts, but this largely based on perception created from looser capital requirements, which make Canada’s banks look “better capitalized” on paper. If the Canadian banks were required to live by the same standards as the American banks (or vice-verse), the American banks would be considered much safer.

Take for example, the Royal Bank of Canada.  RBC’s Tier 1 capital ratio is 13.3% and this is one of the primary ways we assess risks in the banking system.  Meanwhile, Tier 1 capital ratio at Bank of America is slightly lower at 12.89%.  Based on this, Royal Bank of Canada looks better capitalized.  But if we take a look at leverage, we see a radically different story.

RBC’s ratio of Tangible Common Equity to Total Assets is about 3.6%, while Bank of America’s is 6.6%.  This would suggest that Bank of America is significantly less leveraged than RBC.  Leverage, of course, isn’t the only determinant of risk, since some assets are riskier than others.  However, it’s probably a reasonable claim that RBC and BofA have similar asset profiles in their portfolios.

RBC is considered “safer” merely because of Canadian regulations.  It’s safer because Canadian banking regulations say it’s “safer”.  Yet, economically speaking, it would appear that Bank of America is safer.  It’s just that BofA faces greater regulatory risks as a result of American banking standards.

This brings up the disturbing point that it’s not economic realities fueling perceptions of bank solvency. Rather, regulations actually re-shape the way we think about this issue. Too tight regulations actually cause banks to become insolvent, because they are perceived to be “insolvent” under the regulations.

This ultimately shows how our 80 year experiment with tight banking regulations has largely backfired. The banks haven’t become economically safer as a result of the regulations. Rather, they’ve merely adapted to the regulations so that they are perceived to be “safer”. But what happens when the regulations create a misstatement of risk?

I’m certainly not opposed to all banking regulations, but I think the system we’ve created here in the US is largely responsible for our frequent banking crises.  It should be dramatically scaled back and simplified, with a focus on total leverage as measured via tangible common equity to total (tangible) assets.

For instance, require banks to hold TCE of at least 8% of the total asset base; and if they dip below this figure, give them two years to re-comply.   But let’s quit this song and dance on Tier 1 capital, which is a completely arbitrary measure of risk that varies dramatically from nation to nation.

Forbes:  How Much is the Obamacare Mandate Going to Cost You?

Forbes:  How Obamacare Will Make Healthcare Savings Accounts More Costly

Forbes:  The Healthcare Cost Monster Emerges

NRO:  Twelve Reasons to Say No To Medicaid Expansion

IBD:  Obamacare Mandate to Cut Worker Hours, Leaving Poor Worse Off

IBD:  Will Only Suckers Buy Obamacare Insurance?

Reason.com:  Obamacare Finds Its Cost Savings — Stop Paying Doctors

American Spectator:  How Medicaid Expansion Will Create Huge Liabilities for the States

Dr. Milton Wolf:  Obamacare Taxes Mean Layoffs

New York Post:  Obamacare’s New Reality

L.A. Times:  Blue Shield of California Seeks Rate Hikes of Up to 20%

Bloomberg:  Aetna CEO Sees Obamacare Doubling Some Premiums

CATO / NY Post:  Obamacare:  Cuomo, Christie, and State Exchanges

AEI:  Fed Study Suggests a Central Idea Underlying Obamacare is Wrong

AEI:  Will Obama’s Health Care Reform Accelerate the Rise in Healthcare Spending?

AEI:  Obamacare Will Make Healthcare More Expensive, Not Less

RealClearPolitics:  CBO is Increasingly Skeptical About Obamacare

RealClearPolitics:  It’s “I Told You So” on Obamacare

NY Post:  The Wheels Are Coming Off Obamacare

WSJ:  The Devil Made Them Do It:  Senate Democrats Trying To Dodge Responsibility for Obamacare

WSJ:  How Obamacare’s Perverse Incentives Encouraged Arizona Medicaid Expansion

NRO:  Escape from Obamacare:  Small Businesses Look to Self-Insure to Escape Mandate

Reason.com:  The Obamacare Revolt:  Physicians Fight Back Against the Bureaucratization of Health Care

RealClearPolitics:  Healthcare Law Faces Biggest Hurdle:  American Consumers

Forbes:  Connecticut Feels the Burden of Medicaid Expansion

Forbes:  One-Third of Doctors Won’t Accept New Medicaid Patients

MarketWatch:  Obamacare Will Harm Employment

Forbes:  Insurance Premiums Will Spike This Fall

Forbes:  The More Businesses Learn About Obamacare, the More Reluctant They Are to Hire

IBD:  10 Disturbing Facts About Obamacare

USA Today:  Mitch McConnell Editorial, “Obamacare Fails to Keep Promises”

Fiscal Times, “Unravel Obamacare and You Get a Trainwreck“

Last Updated:   April 1, 2013

In this discussion over the “true unemployment rate,” one side argues that the declining LFP rate is a sign that the true unemployment rate is declining much slower than the official number.   On the other end of the spectrum, some have argued that the falling LFP rate is merely the result of a demographic shift with an increasing number of “Baby Boomers” entering into retirement; for this reason, they see the official unemployment rate as a reasonable proxy.  Naturally, there are many people who are in between the two extremes.

My personal take is that the declining LFP rate may be partly explained by demographics, but that overall, the job market is still unhealthy.  If demographics were the primary cause of the low LFP rate, then we should see real wage gains as the supply of labor declined.    This is basic supply and demand; a declining labor force should lead to higher prices.

Instead, we have seen subpar wage growth, which seems to suggest that demographics aren’t the main culprit.  A quick Google search turns up a Wall Street Journal article showing stagnant wage growth over the past 12 months.  Likewise, there’s an interesting and fairly detailed blog on this subject at Zero Hedge:  The Mysterious Case of America’s Negative Real Wage Growth.

I see stagnant wage growth as a chink in the demographic argument, but I decided to take a closer look.  It’s simple enough to eliminate the impact of retiring Baby Boomers on employment figures, by focusing on specific age groups.   For this exercise, I decided to examine the 25 – 34 year old age bracket to see how unemployment and labor force participation has changed for this group since 1994.

Employment for the 25 – 34 Year Old Age Group

First of all, let’s look at the unemployment rate for this age cohort

We can see in this chart that the unemployment rate for this group peaked around August 2009 at 10.5%.  Since then, it has slowly declined to 7.4%.  Now the question becomes how much of this is due to discouraged workers not being counted.  For that, we should look at the labor force participation rate.

In August 2009, the LFP rate for this age bracket was 82.8%.  By March 2013, it had fallen to 81.1%. From this, we can see that at least a good chunk of the drop in unemployment, even in the 25 – 34 year old age bracket, is coming from discouraged workers not being counted in the unemployment statistics.

If we still counted 82.8% of this age bracket as ‘participating in the labor force,’ the unemployment rate for this age group would be 9.3% rather than 7.4%.  This is an improvement from the 10.5% unemployment rate we saw in August ’09, but not nearly as dramatic as the 7.4% unemployment rate seems to imply.

Here’s one final chart that shows a similar stat, and that’s the Employment to Population ratio, for the 25 – 34 age cohort.  This is the most enlightening chart of all.

Here we can see an even more interesting long-term dynamic, with 25 – 34 year old employment peaking in April 2000 at 82.3%.   It declined during the early 00’s recession, before peaking again at 80.0% in March 2007.  Surprisingly, this figure doesn’t bottom until July 2011 when it hits 73.3%.  It has since risen back up to 75.4%.

From the employment-to-population ratio, we can see some disturbing trends in US employment.  It appears we are on a downward trajectory overall, and even at the height of the recovery, we’re still at a lower level than the trough of the last recession (77.5% in Sep ’03).

While we can still debate the true measure of employment, I think this throws the demographic argument mostly out of the water.   Unless one argues that 25 – 34 year olds are retiring in significant numbers, the extraordinarily low employment-to-population ratio here must be explained by something else.   The fact of the matter is that we aren’t creating enough jobs, and that may be the result of structural issues in the US economy.

We’ve seen an increasing number of labor market restrictions implemented by several state governments over the past few decades.  This is on top of an increase in the Federal minimum wage, and soon-to-come implementation of the Affordable Care Act.   One has to wonder if these policy measures bear a bit of responsibility for the declining long-term employment numbers.

There are several issues in the ACA that could hamper economic growth moving forward.  For this series, I want to focus, in particular, on five issues:

(1) Imposition of higher direct taxes,

(2) Imposition of stealth (hidden) taxes,

(3) Restrictions on employment,

(4) Higher costs associated with low-skill workers, and

(5) Restrictions on high-deductible insurance plans

In my first article, I looked at some of the direct taxes implemented by the ACA and how historical tax increases had harmed private domestic investment and consumer spending.  In my second article, I examined how the ACA’s subsidies could create a cost-spiral, and lead to large stealth taxes on many people purchasing insurance.  In my last article, I examined the employment related provisions of the act and how they might impact the restaurant industry.

For this article, I want to look at the act’s prejudice against high-deductible plans.

The Evolution of Employer-Provided Insurance

Our system of employer-provided insurance was somewhat of an accident.  It resulted from price controls in World War II, which artificially capped wages.  Since employers desperately needed labor, they decided to pay employees with large benefit packages that included healthcare.  This allowed them to bypass the war-time wage controls.

Once employers got into the business of providing insurance, the US government helped codify this practice into law, via the US tax code which allowed employers to claim healthcare expenses as a deduction.  The result is that now we have a system where most employer-provided health insurance will cover 80% – 90% of the costs for all medical expenses, even basic services like a routine doctor’s visit, or prescription drugs.  Unfortunately, this has helped create a pattern of overconsumption.

Imagine if auto insurance were similar to health care insurance in the United States.   What if your auto insurance covered oil changes and routine maintenance?  Right now, you can go out and get a basic oil change anywhere from about $20 – $35.  However, if you’ve ever been to Jiffy Lube or any other oil change service companies, you’ve likely noticed that most have premium offerings that can cost anywhere up to $100.

If your auto insurance only required you to make a 10% – 20% co-pay for oil changes, do you think you’d opt more often for the premium offering?  If you’re only paying 10%, that $20 oil change turns into a $2 oil change, while that $100 oil change becomes $10.   $10 versus $2 creates a much different set of incentives for the consumer than $100 versus $20.  For only eight extra bucks, you get a lot of value.   This misaligned incentive showcases one reason (though there are numerous others) why healthcare consumption in the US is too high.

High-Deductible Plans and the ACA’s Restrictions

To help solve this problem, we’ve seen more Americans switch over to high-deductible insurance plans [“HDIPs”].  These are normally coupled with the use of tax-exempt healthcare savings accounts [“HSAs”].  Indeed, the growth of the HDIP / HSA model over the past 6-8 years has been absolutely phenomenal!

In 2005, only 1 million Americans used HDIPs.  By 2011, that number had grown all the way to 11.4 million.  That’s an annualized growth rate of about 50%!

The growth in the large-group insurance market for HDIPs has been particularly spectacular.  Only 162,000 Americans were covered by high-deductible large group plans in 2005.  By 2011, that number has skyrocketed to 6.3 million, an 84% annualized rate of growth.

It’s become clear that due to the rapid growth in healthcare costs in the US, many individuals and employers have turned to high-deductible plans, coupled with HSAs to try to lower insurance costs.   This certainly makes sense, and as I’ve noted before, I’d consider Singapore to have one of the most successful healthcare model in the world, and its universal healthcare system is modeled more along the lines of a HDIP / HSA system.

Oftentimes, when I’ve mentioned Obamacare’s cost issues, many people have intelligently responded that more Americans will simply shift into high-deductible plans.  The only problem with that thesis is that the ACA may effectively outlaws many of those plans.   Obamacare’s calculations of actuarial value are rather unfavorable for HDIPs and HSAs.

In other words, if you want to rely on HDIPs, you may still have to pay the 2.5% mandate income tax.   Which re-emphasizes the main thrust in my last article on how Obamacare will turn into a stealth tax for many Americans.   And this stealth tax is very likely to harm both consumer spending and private investment, which will ultimately harm GDP growth.

More Info and Upcoming Articles

This is my last article on particular issues associated with Obamacare.   Even though this is Part 4 of my series, I’ve really only skimmed the surface on the economic problems inherent in the ACA.   If you want to read more, I keep an updated lists of articles on the ACA on my blog:

List of Obamacare Articles

I will try to write one final article summarizing the problems with the US healthcare system and Obamacare from the bigger-picture perspective.

The minimum wage is the reason why teenage and minority unemployment rates are sky-high. It prohibits many workers from selling their own skills at a reasonable price.

The eurozone crisis, Japan’s currency interventions, and China’s real estate bubble are just a few of the macro issues that people should pay attention to. In the next 12 – 24 months, however, I believe that the Affordable Care Act (frequently called “Obamacare”) will be the greatest obstacle to economic growth in the United States.

There are several issues in the ACA that could hamper economic growth moving forward. For this series, I am focusing on five of them:

(1) Imposition of higher direct taxes,

(2) Imposition of stealth (hidden) taxes,

(3) Restrictions on employment,

(4) Higher costs associated with low-skill workers, and

(5) Restrictions on high-deductible insurance plans

In my first article, I looked at some of the direct taxes implemented by the ACA and how historical tax increases had harmed private domestic investment and consumer spending. In my second article, I examined how the ACA’s subsidies could create a cost-spiral, and lead to large stealth taxes.

For this article, I want to look at the employment related impacts of ACA. My view is that some provisions of the law will not only increase prices of certain goods and services, but that it’s also likely that the restraints on trade will result in many lower- and lower-middle income Americans having less disposable income. This could potentially harm consumer spending, which could be a drag on GDP growth.

29ers and 49ers

The Affordable Care Act is over 2,700 pages long and complex enough so that it will be difficult for anyone to fully comprehend its impacts. Buried inside those 2,700 pages are two particularly notable rules when it comes to employment standards:

(1) The Over 50 Rule

(2) The 30-Hour Rule

The “Over 50 Rule” requires that businesses provide insurance coverage to all full-time employees, if they employ 50 or more employees. The “30-Hour Rule” defines a “full-time employee” to be an employee working more than 30 hours per week. Because of the heavy costs of complying with Obamacare, many companies are going to try to minimize their exposure to the law. That’s why these two provisions are so critical.

To understand how dramatic the impact can be, imagine you run a restaurant with 49 employees. Your profit margins are likely razor thin at 4% and you bring in about $2 million in revenues each year. That gives you a profit of $80,000. Assuming an ACA-compliant healthcare insurance policy costs about $4,000 per year (likely a low-ball estimate), that means that the moment you hire Employee #50, you are potentially subject to $200,000 in new costs. Alternatively, you can pay a $2,000 tax per employee, which would lower the cost to $100,000. Either way, your $80,000 profit just turned negative unless you can pass on the cost increases. For this reason, many small businesses will stay under 50 employees.

Companies that are well over the 50-employee threshold won’t be able to turn back the clock. They can, however, limit their employees’ hours to 25 – 29 per week, thereby minimizing their exposure to the ACA. As a recent commenter on one of my articles stated, these two provisions will create “29ers” and “49ers”; 29ers being employees who can’t work more than 29 hours, and 49ers being companies that can’t hire more than 49 employees.

The Lives of Restaurant Workers

The ACA will dramatically impact many sectors of the economy where low-skilled labor is the norm. This list will include construction, agriculture, retail, and restaurants. For this article, I want to focus on restaurants primarily because it’s simple to find publicly available data on labor costs.

Restaurants are also a sector I’m intimately familiar with. I worked in the pizza industry from age 15 to age 24, at both Domino’s Pizza (DPZ) and Papa John’s (PZZA). It helped pay my bills for many years, and I worked in virtually every role possible, with about every schedule possible. In certain summers, I worked 45+ hour weeks. During one of my most hectic semesters in undergrad, I scaled back to one long 10-hour shift.

You might not think that working 10 hours per week as a delivery driver could support someone, but I averaged about $15 per hour (even when minimum wage was only $5.15), living in East Tennessee, where my rent was only $375 per month. In one Friday night shift, I could normally pull in anywhere from $125 – $175. It was enough to scrape by while I was in undergrad school.

This brings up an important point. I made about $15 per hour at the time, but 2/3 of that was coming from tips and commission. I’m not sure how Waffle House or Applebee’s waitresses fare, but I imagine it’s an even more lopsided ratio for them, given that servers’ minimum wage is typically lower in most states. While I often worked part-time to get through school, many people working as servers, delivery drivers, and cooks work full time. If Obamacare results in hours being cut for many employees, it could result in significant pay cuts.

The Restaurant Industry and the ACA

Nearly every company in the restaurant industry will want to minimize their exposure to the ACA. Darden, the holding company for Olive Garden and Red Lobster, announced in October that they would experiment more with part-time employees to avoid Obamacare’s costs. Darden is one of the largest dine-in restaurant chains in the US, and their experiment resulted in a bunch of negative publicity and a significant backlash. They eventually backtracked, but don’t be surprised if they move forward with their plans anyway, only without talking about it as much.

Darden may have generated negative buzz, but that’s primarily because it’s one of the largest and most well-known chains. In reality, the vast majority of restaurants and retail focused companies in the US will try to find ways to minimize their coverage under the ACA. They will have little other choice, because they’ll be forced to pass on menu price increases otherwise.

That brings up the next question: if restaurants are forced to provide coverage, how much will menu prices have to rise, and how much will this affect demand?

Average Wages at Restaurants

In order to answer some of these questions, I looked at the 10-K filings of several restaurant companies. The goal is to deduce their average wage expense per employee and try to ascertain how the ACA would impact overall wage expenses. This might give us some ball-park estimates of how reliant upon full-time labor these firms are, as well as the extent of price increases in the upcoming year.

There are several notes and caveats here:

(1) I focused on companies that had a significant number of corporate-run stores. It’s much more difficult to get franchisee-related info.

(2) These figures include a mix of corporate office personnel, management, and store-level employees (clerks, cooks, waiters, etc). However, all companies in this data set are dominated by store-level employees, making them more useful for analysis.

(3) Some of these figures are taken from FY 2011 filings and some are taken from FY 2012 filings. This might make a minor difference, but I suspect it wouldn’t significantly impact the results.

Here are the results:

(click to enlarge)

The bottom three rows might need to be explained. The first one, labeled “Avr Wage @ 2000 hours” is merely the average cost per employee divided by 2,000 hours. If we assume that most employees work 40 hours per week, this should be a reasonable estimate of the average wage.

The second bottom row is labeled, “Avr Hours @ $7 / hr.” This assumes that the average employee makes $7 per hour in wages and benefits, in order to estimate the number of hours worked by the average employee. The third bottom row is similar except I used a $9 / hr assumption. I suspect that McDonald’s (MCD) and Papa John’s are closer to $9 or $10 per hour average, since they cannot use servers’ minimum wage, but some of the others might be closer to that, as well.

Obviously, these are imprecise estimates, but they at least give a sense of which companies are more reliant upon full-time labor. The data also shows how susceptible these companies may be to the impact of the ACA.

Glancing over this, it appears that Denny’s (DENN), Brinker (EAT), Darden (DRI), and Cracker Barrel (CBRL) all rely significantly upon full-time labor. Sonic (SONC) is borderline in that camp. Papa John’s and McDonald’s definitely appear to rely more upon part-time labor.

For every dollar of revenue made by Denny’s, it spends nearly 41 cents on wages and benefits. Cracker Barrel and Sonic are in similar territory, with CBRL spending 37 cents and SONC spending 36 cents on wages and benefits for every dollar of revenue generated.

McDonald’s and Papa John’s appear to be the least susceptible to labor costs of the bunch. Brinker and Darden appear to be in the middle, but based on the hour projections, they also appear to be the most dependent upon full-time labor.

Now, let’s take a look at menu price increases.

Menu Price Increases

The ACA is likely to result in menu price increases at most restaurant chains. The extent of these increases depends upon how much of their labor force becomes subject to the ACA’s standards. For this exercise, we’ll look at a few different scenarios, including a few that assume that every employee will become subject to the ACA.

I had to make a few assumptions in this analysis. The first is that the average healthcare policy costs $4,000 and that this translates to about $2 per hour for an employee. This seems reasonable.

The second assumption is more difficult. We need to estimate how much demand will decline as a result of price increases. I decided that for every 5% in price increase, there is a 1% drop in demand. Whether this is reasonable or not is difficult to say without watching this experiment unfold in real time.

Based on this, I plotted out five different scenarios. The first scenario assumes that all employees are subject to the ACA and that the companies all decide to pay the $2,000 tax, rather than insure their employees. The 2nd through 5th scenarios merely plot out percentage increases in wage and benefit expenses, ranging from 10% to 25%. Theoretically, if most of these chains insured all of their employees, they’d be at the high-end of that range (20% – 25%), but since there will be significant avoidance, I suspect that in actuality, we’ll see most of these chains at the low end at around 10%.

Here are the results:

(click to enlarge)

If we assume the 10% scenario is the most probable, and the underlying assumptions are reasonably accurate, then this suggests that we’ll see price increases between 3% to 5% at most restaurant chains. If restaurants decide not to take steps to minimize exposure to the law (as Darden claims it will not), then we could see price increase ranging from about 7% to 12%.

On a $20 ticket, the ‘avoidance’ scenario suggests that the price would rise to around $21.00. The ‘full-coverage’ scenario suggests that the price would rise to around $22.00. These aren’t massive increases, but in a time when restaurants are already struggling to grow profits, it is likely to have some negative impact.

Restaurants Will Adapt — Employees Will Struggle

My expectation is restaurants will adapt fairly well to the ACA within the next 12 months. Many of them will pass on menu price increases, but most of them will minimize the impact of this by re-arranging their schedules, working employees less, and possibly by hiring more part-time workers.

The bigger impact will be on the employees. If you are a full-time waitress, what happens when your hours get cut from 35 – 40 hours down to 25 – 30 hours? Ten hours per week over fifty weeks comes out to 500 hours for the year. If you average $10 per hour in tips and $5 per hour in cash wages, that comes out to about $7,500 for the year. That’s a decline of 25% in annual income. That’s not a small chunk of change for someone who’s scraping by.

What it will mean is that many restaurant workers will have to find other part-time work elsewhere to make ends meet, and that’s not necessarily easy in an environment with such high unemployment. It’s worth mentioning that restaurants aren’t exactly the most flexible of institutions when it comes to scheduling, meaning that many restaurant workers will have to deal with significantly lower wages as a result of the act.

Consumer Spending

This brings us back to consumer spending. While I expect that the ACA will require restaurants and retail chains to raise prices somewhat, I expect the bigger impact will be on the consumer spending end. Many employees will be impacted by restaurants and retail firms re-arranging hours in order to avoid the requirements of the ACA.

Consumer spending makes up about 71% of GDP. This means that any hit it takes can have an inordinately large impact on the economy.

(click to enlarge)
Since World War II, consumer spending has been a major driver of American economic growth. In the past 70 years, we’ve only seen a decline in consumer spending in one year: 2009.

(click to enlarge)
With the implementation of a 2% payroll tax this year, coupled with many of the stealth taxes in Obamacare, most Americans will have lower take-home pay in 2014 and 2015. Add on the fact that a chunk of Americans will see lower gross wages as a result of Obamacare’s “full-time employee” definition, and you get a scenario where it’s completely plausible that consumer expenditures will stagnate.

We already saw subdued growth in consumer spending in 2012, with a 3.6% increase. That might not sound so bad, but that’s a nominal increase (we’d expect it to jump with inflation), and it’s also well below the post-World War II average of 7.0%. This is by no means disastrous, but it does suggest that if consumer spending growth slows down, we’ll have to make up for it either via greater domestic private investment, more exports, or more government spending (where we’re already stretched to the limit).

Economies are Complex Beings

Of course, consumer spending isn’t the only driver of the economy. I expect that Obamacare will hamper spending and investment somewhat, but it won’t necessarily stop a rebound in housing, nor halt America’s progress towards becoming a big energy exporter. For these reasons, even if the ACA has a highly detrimental impact, it won’t automatically create a recession.

As an investor, I’ve found that one can often understand the impact and dynamics of a certain event, but it’s more difficult to figure out how it will affect the bigger picture. Yes, restaurants and retail will be adversely impacted by the ACA. Yes, low-skilled employees will suffer as their companies are forced to pare back their hours. But none of this is likely to stop the impact of the large stimuli being created by both the US Federal government (running large budget deficits) and the US Federal Reserve Bank.

In the 1920′s, while most of the American economy thrived, the agricultural sector was in depression. In the 1990s, when America went through the tech boom, commodities were in one of the worst busts ever. Don’t be too surprised if we see parts of the economy suffer from ACA, but see other parts (such as housing, banking, and oil / gas) hum along.

Conclusions

Obamacare will likely hit restaurants with a double-whammy. It will force most restaurants to raise menu prices, while tax increases (and stealth tax increases), coupled with the ACA’s effective hour restrictions, will result in lower disposable income for the average middle income consumer. Overall, could harm profit growth in the restaurant sector over the next 12-24 months, as well as have an adverse impact on long-term GDP growth.

The interesting trend that Elizabeth Warren fails to note is that the growth in wealth disparity in the US largely coincides with the growth of the welfare / entitlement / protectionist state.  This isn’t a coincidence.

Programs like Social Security, Medicaid, and Medicare have resulted in a massive burden to middle income employees, which have reduced their upward mobility.  We’re frequently told these programs aid the middle class, but they require us to pay a tax of 15.3% every year, and we receive little in return.

Social Security is the most egregious offender in many ways, since over 12.5% of our wealth is taken away from us, and in return, we get the money back only with inflation; or in other words, we make a 0% real return.  Technically, even this is optimistic since the real return you receive on Social Security is based on a complicated formula that is only somewhat related to how much you contribute in.  In reality, it’s possible that the average real return on Social Security is negative.  Even in a worst case scenario, most Americans would make significantly higher returns with a 401(k) account than they do with Social Security.

Meanwhile, Medicaid and Medicare have created massive economic distortions in the healthcare system, which has led to a cost spiral.  In the late 1960′s, US healthcare costs were on par with the rest of the developed world.  By 2013, our costs are significantly higher than everywhere else, and it’s almost perfectly correlated with the rise of Medicare and Medicaid. The fact that our tax system encourages employers to maximize insurance coverage also helps create misaligned incentives that encourage over-consumption, driving up costs further.

It’s also somewhat misleading to say that American incomes haven’t increased over the past several decades.  Rather, what’s more true to say is that our incomes are being increasingly eaten up by healthcare expenses. Expect this trend to continue with the latest Federal abomination:  the Affordable Care Act (i.e. “Obamacare”).

It’s worthwhile to note that the two sectors of the economy where expenses have increased the greatest are in healthcare and education.  These just happen to be the two sectors where the most Federal government intervention has occurred over the past five decades, in order to supposedly promote “affordability.”

In essence, while Elizabeth Warren bemoans rising income inequality in America, it’s the policies that she supports that have fueled this disparity.  It’s true that the rich are getting richer, while the middle class stagnates, but that’s largely because the rich aren’t as vulnerable to the ill-affects of the growing entitlement state, whereas the middle class is buried by it.

This is why individuals are best equipped to make their own economic decisions.  When technocrats try to intervene to improve things, they inevitably make them worse by applying one-size-fits-all solutions to all middle income Americans.  The past fifty years is proof of this.

For many developed nations, entitlement programs have become a major source of economic strain. These programs are often designed on a “pay-as-you-go” basis, so that current retirees are largely funded by taxes from the current working age populace. This contrasts with a 401(k) / compulsory savings type system, where one’s contributions go directly to fund their own retirement.

The difference between the two types of systems is expounded upon by the Washington Post’s Robert Samuelson. In his article, “Would Roosevelt Recognize Today’s Social Security,” he explains how American President Franklin D. Roosevelt initially conceived Social Security more as a compulsory savings system, rather than a pay-as-you-go welfare system. While Samuelson is discussing the issue in the context of the US Social Security system, Italy and most of Europe rely on similar “pay-as-you-go” entitlement programs.

Unfortunately, this type of system creates a nightmare scenario for nations with aging populaces. Things are bad enough in the United States, where we’re worried about having only 2 working-age taxpayers to support 1 retiree in the upcoming years (as opposed to 3 or 4). Italy would love to have “our problem”, as it has one of the ugliest demographic scenarios moving forward.

Population Pyramids

To get a sense of how bad things can become, take a look at the population pyramid for the United States versus Italy. Below, you can see the projected demographic progression in the US over the next 32 years.

(click to enlarge)
The US may see a lower percentage of younger workers in the total pyramid, but at least the base is consistently larger than the top of the pyramid (the retirees). In 2025, the number of Americans projected between the ages of 65 – 69 appears to be in the ballpark of 21 million. Whereas, the number of Americans between the ages of 30 – 34 is projected to be around 24 million. It’s not an ideal ratio to maintain entitlement programs like Social Security, Medicare, and Medicaid, but it’s not completely overwhelming either.

Compare that to Italy’s demographic projections for the same timeframe.

(click to enlarge)

In 2025, Italy is projected to have about 4.0 million people between the ages of 65 – 69, but only 3.6 million between the ages of 30 – 34. It gets worse. By 2035, the 65-69 age range is projected to have about 4.6 million people, while the 30-34 age grouping will still have only 3.3 million. Those aren’t good numbers when your entire system depends on working-age adults paying the way for retirees.

What this means is that either younger Italians are going to have to pay significantly higher taxes to sustain this system, retirement benefits are going to have to be greatly curtailed, or a combination of the two (which is most likely).

Italy already has some of the highest taxes in the world, with tax revenues as a percentage of GDP hitting 43.5% in 2010, so further tax increases are going to be difficult to swallow. It’s difficult to imagine that new taxes wouldn’t constrain Italy’s already horrendous economic growth, and put even more pressure on the system internally.

What About Economic Growth?

Speaking of economic growth, Italy may very well have the worst record of growth in the entire developed world over the past three decades. In my view, per capita income growth is the most important measure of economic progress. It does have a few flaws, as it does not account for income disparities, nor does it account for rapid migration (particularly from lower-income nations). All the same, it’s generally the best measure available for wealth creation, so long as you account for its weaknesses.

The chart below examines thirty “Tier 1 Economies” (i.e. highly developed economies) over the past three decades, examining GDP per capita growth, real GDP growth, and population growth. As you can see Italy’s GDP per capita growth is near the bottom of the chart, in spite of having low increases in population.

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Of the five nations ranked below Italy in per capita income growth, three have significantly higher population growth rates (U.A.E., Saudi Arabia, and New Zealand) which skew their figures downward. This suggests that in reality, those three nations are doing significantly better. Even at 0.7% population growth, it can be argued that Switzerland fared much better than Italy, particularly considering the high level of per capita income it began with in 1980.

I’d argue that Italy has the absolute worst stats of the entire group and Greece is the only nation that could conceivably compete for that title. 1.2% per capita income growth over the past 31 years is particularly dismal, especially considering the extremely low population growth rate of 0.2% in that timeframe. In terms of real GDP growth, Italy ranked 29th out of 30th, with only Greece performing worse.

Things Getting Worse With Time

Italy fares very poorly on the stats in the chart above, but the chart below also showcases how their performance has gotten worse over time. The chart shows annualized GDP and GDP per capita growth rates for similar nations (European nations, US, Canada, Japan, etc). The column headings correspond with the timeframe. For instance, “21-Yr” means “21 Year Annualized Growth Rate.”

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As you can see, Italy’s GDP and GDP per capita growth rates fall over time, with the 51-year growth rate being the highest (for GDP) at 2.7%, while the 11-year growth rate is a paltry 0.4%. None of this is explained by population growth which is relatively similar for both periods at 0.6% for 11-years and 0.4% for the entire 51-year period.

We see the same trend in GDP per capita growth, with the 31-year growth rate at 1.2% and the 11-year growth rate being -0.2%. In fact, with one exception, Italy is the only “Tier 1 Economy” to have negative GDP per capita growth over the past 11 years. That exception (I mentioned earlier) is the U.A.E., where the per capita growth is skewed downward by rapid migration in from lower-income nations.

From this data, we can see that many developed nations that have done a poor job at creating wealth for their citizens over the past few decades (e.g. France, Denmark, Belgium), but Italy appears to be the only one that is actively destroying wealth.

The Euro

If all that weren’t bad enough, the Euro is an even bigger problem. The Euro has destroyed the competitiveness of many of the Southern European economies, including Spain, Portugal, and Italy. It’s estimated that Italy has lost 30% – 40% of its labor competitiveness with Germany as a result of the Euro.

Spain, Portugal, and Italy have all run large current account deficits over much of the past few years. For 2011, Italy’s current account deficit was around 3.1% of GDP, though, it has narrowed since then. Even if that sounds like good news, Italy’s GDP took a significant hit in 2012, falling 2.7% YOY in the October report, possibly a result of significant tax increases.

These tax increases were a major issue in the Italian elections, with voters increasingly angry over them. However, it’s basically a choice between higher taxes and cutting Italy’s massive welfare state. The only hope to offset this would be via growth in exports, which isn’t likely to happen unless Italy exits the eurozone.

Conclusions

While many economists and market analysts expect the Eurozone to hold up under all pressures, I’ve been a bit contrarian in expecting that at least a few (if not more) nations would eventually exit. I see Italy as a prime candidate.

Unless Germany wants to create a perma-bailout fund for Italy over the next two decades, or alternatively, creates some sort of mechanism to redistribute wealth to Italy, I find it difficult to imagine that Italy can stay solvent without absurdly high rates of unemployment and wealth destruction.

It makes vastly more sense for Italy to exit the euro, make structural reforms, and take steps to regain its competitiveness. Indeed, the rise of Beppo Grillo and the Five Star Movement in Italy may very well signal this is the direction the populace is beginning to clamor for.

Italy likely has a rocky road ahead, no matter which direction it goes. But given its structural and demographic problems, it’s only real hope to regain competitiveness and improve its dismal economic situation, is a eurozone exit.

Investment Implications

You might think given my negative outlook for Italy, I would recommend a short on Italian bonds or equities, but much to the contrary, my stance on the eurozone has consistently been to stay away entirely. In spite of the terrible headwinds that Italy will have to deal with over the next decade, everything comes down to the decisions of politicians, which are often arbitrary and haphazard.

I plan on keeping a close eye on nations like Spain, Italy, France, and Portugal over the next few years, but will probably not make any moves long or short until one nation makes a eurozone exit. Then it will be time to reassess things.

In my view, the ACA is the single most likely factor that could hamper US economic growth within the next 12 – 24 months. Not only will the act create major employment headaches, but it also has the potential to hit consumer spending, lower gross private domestic investment, and constrain GDP growth. In a worst-case scenario, it could possibly even lead to recession.

There are several major issues with the act that could cause significant economic harm:

(1) Imposition of higher direct taxes,

(2) Imposition of stealth (hidden) taxes,

(3) Restrictions on employment,

(4) Restrictions on high-deductible insurance plans, and

(5) Higher costs imposed on low-skilled laborers

In Part I of this series, I examined the direct taxes in the ACA. With this article, I want to focus on two even bigger issues: stealth taxes and the healthcare cost-spiral.

My view is that the stealth taxes in the act, combined with the direct taxes, have potential to hit consumer spending and investment significantly, which could lead to lower-than-expected economic growth in 2014.

Imposition of Stealth (Hidden) Taxes

While the direct taxes imposed by Obamacare are no laughing matter, it’s the hidden taxes that have far greater potential for damage. One of the selling points behind the ACA is that it ends “discrimination” in pricing, but this has always been a misleading claim. What proponents of the ACA have termed “pricing discrimination” is actually insurers passing on costs to customers that consume more healthcare. By trying to eliminate this so-called “price discrimination,” the act imposes massive stealth taxes on young, healthy, middle-income Americans.

In a recent IBD article, John Merline explores this issue and asks, “Will Only Suckers Buy Obamacare Insurance?” Merline’s title may overstate the extent of the problem, but the article nevertheless raises important questions, such as why young and healthy Americans will purchase insurance that is priced artificially high?

Proponents of the law often respond to this criticism with two counter-arguments. The first is that the mandate will encourage younger, healthier individuals to buy insurance. The second argument is that the subsidies in the act will encourage individuals with below-average income to purchase insurance.

Both of these arguments are flawed. The mandate is too small to offset the massive distortions inherent in the act. The subsidies argument makes more sense, but begs even more questions, such as how does this impact the non-subsidized consumers? More importantly, why is this arrangement beneficial to begin with?

The ACA Cost-Spiral and the Stealth Tax

In the push to end so-called “price discrimination,” Obamacare tries to eliminate pricing disparities. The actual provisions of the act are infinitely complex, but in a nutshell, the authors decided that it would be beneficial for everyone within certain categories to pay close to the exact same rates for insurance coverage, regardless of consumption (or expected consumption).

This is where the “stealth taxes” come in. If Obamacare pushes premiums towards “the average,” then what happens if you are very healthy, and have below-average healthcare consumption? Conversely, what happens if you are less healthy than average, and have sky-high healthcare consumption?

The answer is that the low-consumption individual pays a “stealth tax” to subsidize the high-consumption individual. In this sense, the ACA actually turns insurers into privatized tax collectors and welfare distribution agencies; a role they are poorly suited for. But it also imposes a huge hidden cost on the economy.

Modeling the Cost Spiral

In order to explain this phenomenon better, I’ve created two models. The first one is a very simplified scenario that shows why a “cost spiral” will occur. The second model adds wages, subsidies, and more accurate taxes to give a better sense of how things will work under the act.

The purpose in this experiment is to not to provide total accuracy, which is virtually impossible here as there are too many variables. Rather, it’s to show how dramatic the cost distortions in the act can become in very simple examples. These models will help explain why many individuals will choose to opt-out, and why many that purchase insurance will pay large stealth taxes for that privilege.

Here is the first stage of the first model. In this simplified model, I’ve created 15 consumers with varying healthcare needs. The two lowest cost individuals (Customers #1 and #2) consume about $500 per year of healthcare over the next decade. The highest cost individual (Customer #15) consumes $15,000 per year over the next decade. The rest of the customers are at various places in between these two extremes.

I explain the rest of the model below the chart.

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Total Value of Coverage

Insurance, at its core, is a product designed to reduce risk associated with lumpy costs. For instance, one consumer may have $500 of healthcare expenses for 9 out of 10 years, but in the other year, they have $7,000 in expenses. The average healthcare expenditure for the 10-year period is $1,150, but that one year with $7,000 in expenses can be difficult to deal with. Insurance solves this problem, by spreading the cash flow stream out over a longer time frame. With insurance, rather than dealing with this lumpy cash flow structure, the customer should instead pay closer to $1,150 annually, plus some premium for risk, and profit for the insurer.

It’s difficult to determine the exact value of this “risk hedge,” but for this model, I assume it’s about 10% of average healthcare expenses. In the third column in the chart above, you see “Value of Risk Hedge” and this is the estimated premium consumers are willing to pay to hedge their cash flows. The fourth column, “Total Value of Coverage” merely adds together the annual healthcare consumption costs with the “value of the risk hedge.”

For instance, an individual that consumes $500 in healthcare per year, gains $100 in value from the cash flow hedge (10% of $500) via insurance, meaning that they gain $600 in total value ($500 in expenses plus $100 for hedging risk) for insurance.

Economic Profit (Loss)

Economic profit (loss) is how much better or worse the customer would be by purchasing insurance under the ACA. For example, if the value is negative $3,000, then the customer would be $3,000 better off if they self-insured.

There is a second column for “economic profit (loss) with taxes.” This column factors in the impact of the mandate tax. I have simplified this as well for the first model, and assumed everyone pays $695 to opt-out. This isn’t strictly true, because the tax gradually phases in from 2014 – 2016, and it’s technically $695 or 2.5% of adjusted gross income, but it’s fine for this simplified model.

The Result of Stage #1

In the simple example above, Customers #1 through #6 would all be significantly worse off under ACA, while Customers #7 and #8 would break-even. Customers #10 – #15 would significantly benefit, with #15 gaining an economic benefit of $13,700 per year.

Customer #9 is the most interesting one here. #9 is slightly worse off under Obamacare, but the mandate tax of $695 means that she will incur an economic loss if she chooses to opt out. Therefore, it still makes sense for her to purchase insurance, even though the ACA imposes an extra cost on her to do so.

Cost Spiral, Stage #2

My view is that some individuals will immediately realize that they are better off opting-out. Some will slowly come to this realization over time. Meanwhile, other may put a psychological value on having insurance and chose to purchase it in spite of the economics. Also remember, while my example looks clear-cut, in reality, none of us know our annual healthcare consumption over the next decade; this uncertainty means that many will continue to buy insurance even if they are significantly worse off.

For stage #2, I decided that Customers #1, #3, and #5 will opt-out after getting a better understanding of their economics. All three are significantly worse off under Obamacare and all three have lower-than-average healthcare costs. This causes the average premium to rise from $4,300 in our prior example to $5,083, an increase of 18.2% for the remaining customers.

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After these three low-cost customers opt-out, we can see that the economics get significantly uglier for the remaining low-cost customers. This pushes Customers #7 and #8 out of “break-even” territory and means they would now be better off paying the mandate tax. Meanwhile Customer #9 is very slightly better off now even after paying the mandate tax.

Stage #3

Let’s move onto Stage #3, where Customers #2, #4, and #7 now opt-out, as well. This causes the average premium to rise from $5,083 to $6,278, a 23.5% increase. This is why I call this a “cost spiral;” as more low-cost customers continue to opt-out, the economics become less and less attractive to the remaining customers.

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With six consumers opting out, we can now see that Customers #1 through #9 are all better off not buying insurance and paying the mandate’s penalty tax. Customer #10′s economics are also starting to look very ugly, as they would be slightly better off paying the mandate penalty tax, as well. Even Customer #11 is starting to get squeezed in this scenario, with only Customers #12 – #15 seeing clear benefits.

This cost-spiral showcases how Obamacare can become a stealth tax. Customers that do not chose to opt-out will be subject to higher healthcare premiums that are, in effect, hidden taxes. Those that do chose to opt-out will be subject to a direct tax of either $695 or 2.5% of gross income (whichever is greater). For these reasons, it’s difficult to argue then that this act does not implement a significant tax increase on many middle income earners.

The Cost-Spiral with Wages, Subsidies, and Taxes

Let’s add a little complexity to the model above. In this new model, we still have 15 customers. 8 customers earn $30,000 in taxable income per year. The other 7 customers earn $50,000 in taxable income.

Under the ACA, individuals that make less than 400% of the poverty limit are eligible for scaling subsidies. The Federal poverty line is slightly over $11,000 for an individual with no dependents. This means that subsidies are available up to around $45,000 in taxable income. Subsidies vary based on income, but in the $30K – $45K range, the rule (i.e. subsidy) is that an individual pays no more than 9.5% of adjusted gross income in insurance premiums.

For the second model, I’ve estimated the subsidies, and I’ve also more precisely calculated the mandate penalty tax, which when fully implemented, will be equal to $695 or 2.5% of taxable income, whichever is greater. In these examples, “wages” are analogous to “taxable income” to keep things simple.

Stage #1 of the adjusted model is below.

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You can immediately see that things change quite a bit with the subsidies included. In order to account for the subsidies, however, I had to increase the costs for all the non-subsidized customers, which makes a huge impact. Even with the higher tax (2.5% of income, rather than a flat $695), the economics look even worse for Customer #2, who earns $50K in taxable income and has $500 in annual healthcare consumption. He now is $4,107 better off by opting-out, even in spite of a $1,250 mandate tax.

Meanwhile, Customer #5, who earns $30K and has $2,000 in consumption looks significantly better off than in the last example, with an economic loss of only $450 (versus $1900 before). As you may be able to see, the clear difference in this example is that those who earn $30K are much better off than in the first model and those earning $50K are much worse off.

Stage #2

For Stage #2, I decide that Customers #2, #4, and #6 all opt-out and pay the mandate tax of $1,250. All three are significantly better off going this route. Instead of blacking all the data for the opted-out customers, I’ll allow you to see their economic losses if they had purchased insurance under ACA.

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Stage #2 raises the premium for the $50K customers from $5,957 to $6,740, a 13% increase. It does not affect the premiums for the $30K customers who gain subsidies. The effect is to make the economics significantly uglier for many of the remaining $50K customers, with Customer #8 being particularly affected.

In Stage #3, I assume that Customer #8 and the partly subsidized Customer #1 opt-out. Even though Customer #1 is receiving subsidies, he’s still significantly better off opting out.

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After this change, the average premium for the unsubsidized customers rises to $7,407, a 10% increase. The economics for Customer #10 are looking uglier with two more customers opting-out. Naturally, the subsidized customers are immune to this affect.

This leads to an interesting conclusion that the act may force individuals making slightly-above median income to pay higher and higher stealth taxes every year to subsidize those who happen to fall under an arbitrarily set income level. Hence, one may be better off making $43,000 in taxable income rather than $46,000.

The Overall Impact of the Cost-Spiral

My models are not meant to completely accurately show what will happen. Indeed, it’s impossible to create a model with 320 million different people and all the provisions of the law. Nevertheless, we can see on a small scale in these models how some of the provisions in this act can create very significant economic distortions. It leads to stealth taxes that will likely deprive many younger, middle-income consumers of income that would otherwise used for savings or consumption.

In my second model above (in Stage #1), an individual making $50,000 with $1,000 average annual healthcare consumption would be paying a stealth tax of $5,300. That’s about 10.6% of their taxable income. If they opt-out, it drops to a 2.5% tax. Either way, that’s a significant chunk of change and seems very likely to result in many middle-income consumers having significantly less take-home pay in the next few years. For this reason, it’s probable that one result of the ACA will be lower consumer spending.

In my prior article, I noted how some large retailers, such as Wal-Mart, are already feeling the impact of the payroll tax expiration, which imposed a 2% tax on most lower- and middle-income earners. The ACA includes both a 0.9% Medicare tax, and the stealth taxes mentioned here.  Many consumers could find themselves paying new stealth (or direct) taxes ranging from 2.5% – 11% of income.

How much of an increase is this? Quite a lot!

I looked at the Tax Foundation’s tax calculator to get a sense of how much our hypothetical consumer would pay. In my model above, I assumed $50,000 in taxable income, which would be about $60,000 in gross income. Tax Foundation estimates that this individual would currently pay $13,000 in Federal taxes, or about 22% of income.

If that individual pays the stealth taxes, their effective tax rate could jump from 22% to 33%! Even if they opt-out of ACA insurance, it could still be in the 25.4% range, a 15.5% increase in tax burden. It’s also equal to a 27% tax increase over the course of a few years (including the fiscal cliff deal taxes).

The Beneficiaries

This of course begs the question, if some individuals are worse off under ACA, what about those who are better off? Won’t they have more money to spend?

I suspect the answer is yes, but I suspect it’s not a 1:1 ratio or anywhere close to that. Much of that extra money is going towards more healthcare expenditures (not to mention other government expenses), and my view is that the price of healthcare is so high in the US largely because of Federal programs such as Medicare and Medicaid that result in artificially reduced supply, stealth taxes (e.g. Medicaid causes private insurance premiums to go up), and very inefficient bureaucracy.

So while some high-consumption individuals will effectively get a tax cut, not all of that money is going directly back into the real economy. A good portion of it goes towards waste. Regardless, the direct taxes will almost certainly result in less money in the private sector.

Conclusions

It’s likely that the direct taxes mentioned in Part I of this series, coupled with the stealth taxes mentioned here, will lead to reduced or stagnant consumer spending. Since consumer spending is 71% of the US economy, any reduction in that would need to be offset by a large increase in either exports or gross private domestic investment to see further economic growth. It’s difficult to comment on exports, but at least a large increase in private investment seems unlikely with higher taxes.

For this reason, it seems likely to me that real GDP growth in 2014 will be lower than expected. The Federal Reserve and CBO are forecasting growth in the 3.0% – 3.5% range; I think it’s completely possible we see sub-2% growth instead, which might hamper the stock market, or even lead to a market downturn.

In my upcoming articles, I’ll examine the ACA’s impact on employment, focus on industries that are likely to get hit, and talk about some of the investment implications. I’ll also talk about how my own investment thesis ties in with the ACA.

In one regard, I am a classical value investor. I seek out companies with strong fundamentals that are trading at discounts to their intrinsic values. This has proven to be an extremely effective long-term wealth creation strategy, but I’m also very cognizant that there are assumptions underlying value investment. When one of those assumptions gets undermined, what once looked like “value” can suddenly become very expensive.

There are numerous political currents that could undermine value in the next few years, including the ongoing troubles in the eurozone, Japan’s attempts to weaken its currency, and China’s fixed asset bubble. However, the one being most ignored by mainstream investors right now is the Patient Protection and Affordable Care Act, more commonly known as “Obamacare.”

The Affordable Care Act could have a destructive impact on employment, price levels, consumer spending, and overall economic growth in the United States in the upcoming years. At the very least, it will probably result in a relative decline in the growth rate for GDP, and at worst, could even push the US economy into outright recession in 2014.

The Affordable Care Act

There are several issues created by the ACA that I believe could have a significantly negative impact on the economy in 2014 and beyond:

(1) Imposition of higher direct taxes,

(2) Imposition of stealth (hidden) taxes,

(3) Restrictions on employment,

(4) Restrictions on high-deductible insurance plans, and

(5) Higher costs imposed on low-skilled laborers

In this article, I will focus largely on direct taxes. In Part II, I will focus on stealth taxes and the Obamacare cost-spiral. In Part III, I’ll look at impacts on employment, certain industries, and offsetting currents, such as government spending and monetary policy.

Imposition of Higher Direct Taxes

One of the more obvious ways that Obamacare could drag down economic growth is through direct taxes. This is particularly noteworthy because we’re already seeing signs that the expiration of the payroll tax cut, as part of the “fiscal cliff” deal, might be harming consumer spending. Wal-Mart (WMT) is reporting abnormally slow February sales, which have come on top of an unusually slow January. Certainly other retailers are struggling as well. If a 2% tax on middle income earners is having such a significant impact on consumer spending, imagine how the ACA, which imposes several direct and stealth taxes, could impact the economy?

Consumer spending currently constitutes about 71% of US GDP. This means even a minor drop in spending could have huge implications. Even if spending flatlines (rather than outright declining), that could result in a sub-1% GDP growth rate.

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Since 1939, there has only been one instance of declining US consumer spending. That came in 2009, at the height of our current economic malaise. I’ll restate that in another way: from 1945 – 2007, every recession in the United States was caused by a fall in private domestic investment and/or trade. If consumer spending were to decline or stay flat, it would mean that private investment would need to jump considerably to stave off recession.

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The fiscal cliff tax increases are important because Obamacare is packed with similar tax increases. The ACA levies a 0.9% Medicare tax on families with incomes over $200,000, as well as a 3.8% tax on “unearned income” from high-income taxpayers. Even ignoring the other aspects of the bill, the 3.8% “unearned income” tax should almost certainly result in reduced private direct investment ["PDI"], another key component of GDP. Historically, there’s a high correlation between tax increases and drops in PDI. During the Great Depression, we saw two instances of this.

Great Depression Tax Increases

Herbert Hoover signed the Revenue Act of 1932, which implemented arguably the largest peacetime tax increase in American history. It’s often noted that it raised the top rate from 25% to 63%, but more broadly, it raised taxes significantly on every single American, even doubling the rates for many middle income individuals. It also introduced several new excise taxes, which are often overlooked by modern observers. To make matters worse, these taxes were implemented immediately for the 1932 tax year, rather than being phased in gradually during future years.

The result was that gross private domestic investment fell 78% in one year; the single largest decline in the data series, which dates back to 1929. Moreover, consumer spending fell 20%; also the largest decline in the series. For comparative purposes, in 2009, PDI fell 26% and consumer spending fell a mere 1.9%.

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In spite of the disastrous results of the 1932 tax increases, Roosevelt implemented several more tax increases between 1935 and 1938, with more of an eye on “soaking the rich.” While not quite as dramatic as the Hoover tax increases, the Roosevelt taxes led to consumer spending falling 3.7%. This might not be as huge as the 20% fall in 1932, but it’s still one of the largest declines in the data series. More ominously, PDI fell 34% in one year and was the primary driver pushing the US back into recession.

If the chart above is ugly, the charts below are even uglier. In real terms, PDI did not hit its 1929 levels again until World War II, and even that was fleeting. It took till 1946 till PDI sustainably stayed above the 1929 mark. In essence, we had something close to a 17-year black hole for investment. No wonder unemployment was so astronomically high in the Great Depression.

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Also, it’s interesting to take a look at PDI as a percentage of GDP. From 1946 to 2008, we saw a “normal” range of private investment take form at 14% – 20% of GDP. After Hoover’s 1932 tax increases, PDI fell all the way to 2.2% of GDP. It steadily rose for a few years, before plunging again in 1938 to 8.2%.

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All this is to say, be wary of tax increases that could negatively impact private investment and consumer spending. They could have a larger effect on the economy than people are anticipating.

Etcetra

Other direct taxes in the ACA include an annual fee on health insurance providers, an excise tax on so-called “luxury” plans, fees on manufacturers of branded drugs, and the increasingly controversial 2.3% excise tax on medical device makers. Overall, there are a lot of new taxes being implemented within the next 12 months. If the Great Depression should have taught us anything, it’s that these higher taxes could adversely impact economic growth more than we expect.

Conclusions

If the fiscal cliff tax increases are already putting a dent in consumer spending, it stands to reason that the tax increases embedded in the Affordable Care Act could also create an additional hit to the economy.

The Federal Reserve is forecasting 3.0% – 3.5% GDP growth for 2014. The CBO is even more unrealistic, forecasting 3.4% real GDP growth in 2014, and 3.6% average real GDP growth from 2015 – 2018. These estimates seem extremely unlikely to be met.

While I can’t say for certain how much the ACA’s tax increases will harm the economy, I’d wager to guess we’ll see sub-2% GDP growth in 2014, if not outright recession. For this reason, it makes sense for investors to proceed with caution.

In my upcoming articles, I will examine an even larger issue with the Affordable Care Act: stealth taxes. I’ll also look at a probable cost-spiral, the ACA’s impacts on particular sectors of the economy, and offsetting factors, such as government spending and monetary policy. Finally, I’ll look at the investment implications and how the ACA ties in with my own investment theses.