Fearing recession, Wall Street eyes election warily

NEW YORK (Reuters) - As Americans begin the process of choosing their next president, some Wall Street analysts worry that the election results could pave the way for higher taxes that would hurt a U.S. economy already in a slowdown.

Voters in Iowa began the process on Thursday of winnowing the Republican and Democratic presidential fields. The two party nominees will contest the presidential election in November and the winner will take office in January 2009.

While Wall Street investment banks and securities firms, which manage trillions of dollars and sway markets across the globe, cannot predict the winner, they are already factoring in the possibility of tax hikes under a new administration and Congress.

"I think there are lots of political risks out there," said Morgan Stanley chief economist Richard Berner, whose bank last month reported its first quarterly loss in its 74-year history after making bad bets on risky mortgages.

Wall Street, which tends to favor Republicans, fears that plans offered by Democratic candidate to reverse tax cuts put in place during President George W. Bush's tenure would hurt an economy already under pressure from a prolonged housing slump and spreading credit shortage.

Wall Street economists believe those tax cuts helped the economy recover quickly from the recession that followed the September 11, 2001 attacks and weather the subsequent shock of caused by Hurricane Katrina in 2005.

"Letting any of the tax cuts lapse and going back to prior tax rates would be essentially a tax increase and that would be damaging," said Alan Sinai at Decision Economics in Boston.

Several Democrats have proposed rolling back the tax cuts, which they argue overwhelmingly benefited big corporations and the richest Americans, including many on Wall Street.

Former North Carolina Sen. John Edwards has proposed raising the top tax rate on long-term capital gains to 28 percent. Wall Street sees this as specifically targeting the multitrillion hedge fund industry which, under the current code, is able to take in hefty fees from its investors and pay only 15 percent on those earnings.

"I think what Wall Street is mostly thinking here is that you can't tax your way to better revenues," said James Glassman, economist at JP Morgan, the nation's third-largest bank. "It's the last thing you want to do."

MAKE CUTS PERMANENT

In contrast, Republicans like former Massachusetts Gov. Mitt Romney want to make permanent the Bush tax cuts, some of are set to expire in as early as 2010.

One Republican candidate, former Arkansas Gov. Mike Huckabee, has proposed replacing the federal income and payroll taxes with a national sales tax, but Wall Street analysts do not take that plan seriously because it is seen as too sweeping to be politically feasible.

Both Democrat Hillary Clinton and Republican Rudy Giuliani are seen as friendly to Wall Street because of their strong ties to New York City, which Clinton represents in the Senate and Giuliani used to run as mayor.

"They don't want to touch this because it's New York," said Glassman.

But analysts agree the next president, whether Democrat or Republican, should make it a priority to reform the alternative minimum tax which was originally intended to target the richest Americans but now encompasses more people every year.

"The thing that most politicians agree on is that we need to fix the AMT," said Berner.

Congress was able to extend what is commonly called a "patch" for a year to keep middle income families from having to pay the higher tax but politicians agree they need a more permanent solution.

Wall Street's financial role in the political process has been growing in recent election cycles. According to the nonpartisan Center for Responsive Politics, the securities and investment industry showed the biggest increase in political contributions since 2004 of any sector.

(Reporting By Joanne Morrison; Editing by Alan Elsner)