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Analysis: Some investors open to higher tax to trim deficit

By Steven C. Johnson

NEW YORK (Reuters) - Nobody likes taxes, and much of Wall Street has poured money into Mitt Romney campaign coffers to avoid paying higher ones.

Yet a surprising number of top money managers say they are willing to pay modestly higher rates. They reason that revenue-raising measures are an essential complement to the spending cuts they say are needed to curb the massive U.S. budget deficit.

"It's kind of like taking a distasteful medicine. On the way down, it may not be pleasant," said Ron Florance, who helps manage assets worth $169 billion at Wells Fargo Private Bank. "But in the end, it contributes to longer-term health, and that's what we're looking for at this point."

In recent weeks, Goldman Sachs CEO Lloyd Blankfein and JPMorgan's Jamie Dimon became the latest Wall Street heavyweights to say they would be willing to pay more in exchange for a deal to balance the country's books.

Conventional wisdom in the world of finance and investing says higher taxes, particularly in today's fragile economic climate, would stifle wealth creation, suppress hiring and condemn the economy to an extended stretch of slow growth.

Hedge fund managers like Lee Cooperman and private equity heads such as Stephen Schwarzman have been especially vocal critics of President Barack Obama, accusing him of inciting class warfare. Obama wants to let Bush-era tax cuts on income, capital gains and dividends expire for households earning more than $250,000.

Romney advocates cutting taxes by 20 percent and broadening the tax base by closing loopholes, though he's offered few details. The financial services industry had contributed some $16 million to Romney through October, compared with $4 million for Obama, according to the nonprofit Center for Responsive Politics.

Yet many who manage money for investors with at least $1 million in assets said in recent conversations they do not believe a modest rise in taxes on high-income earners would upend the economy, markets or individual portfolios.

"It only really impacts the higher income taxpayer," said Joseph Balestrino, who helps oversee $360 billion in assets at Federated Investment Management. "They won't like it, but they're not going to be worried about putting food on the table, and I don't think it will significantly alter their spending patterns."

Some said raising taxes might even be a much-needed first step toward deficit reduction. Congress has been too bitterly divided to compromise on a long-term fiscal repair plan.

"My belief is the positive benefits of dealing with the long-term deficit problem would well outweigh any negative consequences of higher taxes," said Jim McDonald, chief investment strategist at Northern Trust, which runs assets worth $704 billion.

SIMPLE MATH

The U.S. deficit in 2012 will top $1 trillion for a fourth straight year, pushing the national debt past $16 trillion. While the United States currently borrows at record low interest rates, investors worry this will change.

"We must stabilize, then reduce the national debt, or we could spend $1 trillion a year in interest alone by 2020," warned the authors of a 2010 Congressional committee's deficit-reduction plan known as Simpson-Bowles. Neither Obama nor Romney has embraced the plan in its entirety.

The issue will come to a head even before the winner of the November 6 election is sworn in. In January, $500 billion of Bush-era tax cuts for all earners will expire and about $100 billion of automatic spending cuts will kick in.

Markets expect Congress will avoid letting all of this happen at once for fear it would plunge a fragile economy back into recession. But many say they want lawmakers to draft a long-term plan to reduce the deficit gradually over time.

"It has to be a balancing act," Balestrino said. "You're not going to just cut taxes like Romney wants to do or just increase spending like Obama seems to want to do."

Most investors agree long-term deficit reduction would require painful spending cuts, including for programs such as Social Security and Medicare struggling to keep up with an aging population.

But many also say taxes should be on the table too, especially for top earners whose effective tax rates are at the lowest level in decades.

According to the nonpartisan Tax Policy Center, federal tax revenue in 2010 fell to levels not seen since shortly after World War II, the result of slow growth and the sweeping but temporary tax cuts passed when George W. Bush was president.

"Simple math says the U.S. government will have to increase revenues to make a dent in the deficit," strategists at BlackRock, a giant in the U.S. investment world with $3.68 trillion in assets, said in a recent note to clients.

Bill Stone, who helps manage $110 billion as chief investment strategist at PNC Wealth Management, said the debt crises in Greece and other European countries have opened some of his clients' eyes to the danger of unchecked deficits.

"I get the sense that people think there should be some degree of shared sacrifice to close the fiscal gap," he said

Mark Lamkin, head of Louisville, Kentucky-based Lamkin Wealth Management, said most of his clients -- small business owners and retirees with up to $5 million in investable assets -- would accept higher rates, too, even though he says the majority intend to vote for Romney over Obama on November 6.

"From an investment standpoint, you always hate to see higher taxes. I'm a low-tax guy but I would be happy with a modest tax increase in exchange for cuts in spending and a move toward fiscal sanity," he said.

Obama claims letting Bush-era tax cuts for the wealthy expire would raise $850 billion over 10 years. Top marginal income tax rates would rise to 39.6 percent and 36 percent, where they stood under Bill Clinton, from 35 and 33 percent. Capital gains taxes would rise to 20 percent from 15 percent for the top two income brackets.

DEALING WITH DIVIDENDS

One ticklish area involves taxes on dividends, which would revert from 15 percent to at least 40 percent if the Bush tax cuts expire.

Andy Busch, global currency and public policy strategist at BMO Capital Markets, said that would be "highly disruptive" for the stock market at a time when record low interest rates have driven investors toward dividend stocks to generate return.

Higher dividend taxes were less disruptive in the 1990s, he said, when higher interest rates and a strong economy made growth stocks more attractive.

Wells Fargo's Florance said such a large jump would "change the way companies reward investors who have put faith in those companies. It's a big deal."

But some investors said record-low bond yields will keep dividends in vogue even at higher tax rates. And many said they expect a compromise that pushes the rate up to 20 to 25 percent rather than 40 percent.

That would keep dividend-paying stocks "attractive to those in the highest income brackets," BlackRock strategists said.

Jeffrey Gundlach, chief executive officer at DoubleLine Capital, which oversees $41 billion, said he expects taxes to rise but adds the focus on what rate the rich pay is too narrow and by itself would do very little to reduce the deficit.

A more credible approach, he said, would also include painful benefit cuts and overhauling a tax code filled with more than 100 credits and deductions. Some, such as those for mortgage interest and charitable donations, are very popular.

"People are attracted to the idea of a more just code without so many tax breaks, but of course, it's only attractive until you learn your breaks are the ones getting discontinued," PNC's Stone said.

Both Obama and Romney say they support an overhaul but have been vague about the crucial details.

Gundlach also said lawmakers should at least consider raising corporate taxes.

Obama and Romney want to cut corporate taxes, which the Tax Policy Center said accounted for 1.3 percent of gross domestic product in 2010, down from 5 percent to 6 percent in 1950.

"I'm not necessarily advocating we do this, but let's at least talk honestly about what the situation is," Gundlach said.

(Editing by David Gaffen and David Gregorio)

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