U.S. Midterm Elections

Energy Strategist (09/02/2010)
"With Q2 earnings season in the rearview, attention is turning to a slew of economic data due out over the next two weeks, including the all-important August employment report that will come out Friday. Even more important, markets are typically volatile in the lead up to midterm elections.

Rather than listen to endless political banter on news channels, I watch the latest prices on the 'Intrade' political markets. Intrade is a platform that, effectively, allows investors to bet on an election's outcome.

Intrade prices currently indicate that there's a better-than-75% chance Republicans will take control of the House of Representatives. . .[and] suggest a less-than-30% chance that Republicans will take control of the Senate, though the GOP is likely to take numerous new seats. If these results hold up, expect gridlock. With the Republicans in control of the House, the Democrats will lose control of the legislative agenda.

Although legislative gridlock is usually a positive for the broader market, taxes are still a concern. If Congress fails to act, U.S. taxes will revert to their levels prior to the Bush tax cuts. The top marginal rate will increase to 39.6% from the current rate of 35%, and the tax payable on dividend income will revert to a taxpayer's full marginal tax rate.

I don't think this is the likely outcome, even if Congress is gridlocked. Republicans and Democrats alike will be keen to avoid the stigma of raising taxes amid an economic downturn. Expect a compromise.

Regardless of the outcome, progress on a tax compromise to be a significant upside catalyst for stocks in Q4, especially if Congress decides to make some tax cuts—such as lower dividend tax rates—permanent.

Master limited partnerships (MLP) stand to benefit the most from any tax increase. MLPs won't be subject to higher dividend taxes because they pay distributions that are reported on a K-1 form. The true beauty of distributions is that a significant portion of the income you receive will be taxed as a return of capital. This does not literally mean that the MLP is returning your investment. MLPs don't pay corporate income taxes; instead, MLPs pass through their profits to unit holders (shareholders) in the form of regular quarterly distributions. In addition to profits, the MLP also passes through depreciation and other tax shields."

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