IRS-Abuse of Power-Markets

“At the same time the IRS was targeting tea-party groups, the tax agency took the unusual step of trying to impose gift taxes on donors to a prominent conservative advocacy group formed in 2007 to build support for President George W. Bush’s Iraq troop surge” (Wall St. Journal, May 31).

Abuse of power is an anathema to most Americans. We should be and mostly are rightfully outraged when a government agency is caught abusing its authority by targeting specific groups. The issue is NOT the target, whether political right or left; nor the cause, whether the Tea Party or the Sierra Club.  The issue IS our government’s function or failure?

The revelations concerning abuse of power are a potential game changer for the Obama administration and therefore for the President’s policy agenda and for the financial markets. Let’s take these potential ramifications in order.

First, let’s examine the abuse of power with an interim update.

We are watching the sequential revelations about the IRS and its targeting of the Tea Party. The practice was revealed in an Inspector General’s report and is now known to have started in February 2010. Investigations continue and are broadening. The records of eighty-eight IRS personnel are being examined. The head of an IRS section invoked the US Constitution’s Fifth Amendment protection clause against self-incrimination when she appeared before a congressional committee. It is now known that the IRS purposefully selected certain groups for extra scrutiny. Keywords used to screen targets included “tea party,” “9/12,” and “patriot.” In addition, the weekend news discloses that the IRS purposefully targeted and unleashed gift tax audits on some who were contributors to conservative groups under IRS section 501(c)(4). See the Wall St. Journal article cited above for details.

Who knew what and when did they know it?

A Pew poll finds that 42% of Americans believe the IRS acted on orders from the administration, but so far no one has uncovered any evidence that the IRS scandal runs directly to the White House. Questions have arisen about the 157 logged visits or entrance clearances of the IRS commissioner to the Obama White House. Most are being explained as meetings dealing with the development of Obamacare and the role of the IRS in its implementation. So far, there is no direct link to the President or to the then Secretary of the Treasury, Tim Geithner. In the wake of the scandal, President Obama has fired the acting head of the IRS.

White House Spokesperson Jay Carney originally suggested that nothing was known in the White House until the media disclosed the Inspector General’s report about IRS abuses. “Now Mr. Carney admits that Mr. Obama’s chief of staff, Denis McDonough, not only knew about the nature of the scandal, but had discussed with Treasury staff when the report on it would be released” (The Economist, May 25). What stops at the Chief of Staff and what does the Chief of Staff tell the President and when? We may find out.

The IRS is a convenient target and not just because of the stupid “dancing video” expenditure.  The criticism seems well-deserved. This agency of government is not liked. Who likes the tax collector?

The agency is reputed to deliver poor service. It admits it answered only 57% of telephone calls on April 15, our official American tax cutoff date. It failed to reply to correspondence about half the time last year. It answered about 68% of the calls it received in 2012, down from 88% in 2004. The average wait time on a call ballooned from three minutes to seventeen minutes. Meanwhile, Congress has cut funding for the IRS. The agency will close five additional days during the summer and will cut its training budget by 80%.

Congress makes things worse. Remember it is the Congress that enacts tax law, and it is the Congress that changes it.

The IRS tax code is so complex as to be bewildering. It contains nearly 4 million words and has had 4700 changes in the last decade. Americans spend over 6 billion hours a year attempting to comply with it. Nearly 90% of all filers pay to obtain help to deal with the IRS code. Only one of seven independent businesses believes that the IRS code is fair. Meanwhile, about $400 billion in taxes is owed but not collected in a given year.

So where does this lead us?

More about the Obama administration and the IRS will be revealed as the investigations proceed. Any criminality will come under fierce scrutiny, and the Attorney General is already under fire because of his actions regarding journalists and “snooping.” Many observers suggest that the President’s expressions of confidence in the Attorney General are for public consumption only and that a resignation is inevitable.

The Economist editorial (May 25) sums it up well: “The snooping scandal is murkier, and seems to have involved an abuse of power. But the IRS scandal is unambiguously outrageous.”

The lessons of history do not bode well for the rest of Obama’s term. Scandals haunt Presidents and can derail them. Warren Harding suffered from the Tea Pot Dome bribery issues in the early 1920s. His VP and then successor, Calvin Coolidge, was able to restore some confidence in government after Harding’s death. Richard Nixon’s Watergate scandal discredited him and led to his resignation under pressure of an impeachment action. Note that in both cases the US political agenda suffered from the distractions of congressional investigations. Note also that stock markets developed weakness during both scandal-ridden periods. The markets subsequently recovered strongly after the scandal revelations had run their course.

Scandal could turn President Obama into an early lame duck. Next year the focus will be on midterm elections. Unless the Democrats can sweep both houses, no significant congressional decisions are likely until the next presidential contest is resolved. Meanwhile, the scandals have seemed to weaken the chances of Democrats to make any gains in the House of Representatives. It now appears that Republicans may actually gain some seats. In the Senate, 21 Democratic and 14 Republican seats are up. Six Democrats have announced retirement, and 2 Republicans have done so. In the Senate, it is likely that the current 55-45 Democrat majority will narrow. According to our Washington sources, the 4 “toss-up” races (IA, MT, SD, and WV) all involve Democrats. It seems as if the biggest threat to the Republicans will come from Tea Party primary victories. In such cases, an extreme right winger wins the primary and thereby sets things up for a Democrat to win the general election. That sequence of events has cost the Republicans 4 or 5 Senate seats during the last two election cycles.

So we end this commentary with the following conclusions. What looked like a strong advancement of the Obama legacy has been weakened materially by scandal. History suggests that scandal increases risk to markets. Resolution of scandal usually reverses the market weakness. So far, the present scandal has not reached the president. If it does, the outlook worsens materially. We would not sell positions based on the current state of revelations about the IRS or the Attorney General. Market actions are still driven by the economic outlook and the central banks’ QE. That could change if the White House gets implicated more deeply in the scandals.

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