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The taxman cometh.
Prepare to be worried about something new. For decades, the overarching macro drivers of markets centered on monetary policy with related concerns about financial stability. Recently, trade policy and risks to globalization have come on the radar, along with what are seen as a set of binary risks concerning “populism.” More specifically, what are the chances that existing governments are toppled?
Rising taxes have not been a major source of market concern for two generations. The few tax increases that have been implemented have tended to be narrow and specific, billed merely as the reversal of prior tax cuts or sold politically as payments for specific and popular projects. Full-throated support for higher taxation, or for greater redistribution as an end in itself, has been lacking.
But that hasn’t been the norm historically. As the late George Harrison reminded us, in the top marginal rate of income tax in the U.K. was 95 percent in 1966. Decades later, he was still unhappy about it and another angry young man was using his riff — and would continue to use it. In the U.S. and the U.K., lower top marginal rates enjoyed in recent years have been a historical anomaly:
This chart comes from Deutsche Bank foreign-exchange strategist George Saravelos in a report ominously titled “Beware the taxman.” A top rate of 70 percent, as loudly proposed by youthful Democrats in Congress, would still be below the level that held for several decades of economic expansion after the second world war.
Major defeats for center-left political candidates are partly the reason for the decline in top marginal tax rates, but now the topic is back on the table. This extraordinary chart from Saravelos could perhaps be of use to progressive Democrats. In terms of post-tax income, the 34 years to 1980 (when Ronald Reagan and the low-tax agenda arrived) saw virtually everybody in the U.S. double their income, apart from the very wealthy. The years since have seen almost half the population fail to register any growth in their income at all, while the very wealthiest have enjoyed extraordinary growth.
This generosity to the rich has, obviously, not helped those who are poorer very much. And it is hard to claim that it has aided economic growth. Most intriguingly, the Saravelos report shows that huge variations in top marginal rates have had a minimal impact on the actual burden of taxation as a whole. Tax as a proportion of gross domestic product was broadly unchanged before and after Reagan and (at a considerably higher level) in the U.K. before and after Margaret Thatcher:
It doesn’t look as though the burden that taxes place on economic growth has been lightened in the last generation, but rather that a distributional decision has been taken to be tougher on the poor and more generous to the rich.
This leads to a fascinating economic debate. But even if those arguing for more punitive taxation on the rich can call research by large international banks to their aid, we can assume that any increase in the chances of high top marginal tax rates will be viewed as emphatically market-negative. This, in part, reflects the political beliefs of investors, but there is more to it. To quote Saravelos:
In recent research we have argued that political uncertainty may become a negative driver for the dollar later in the year. Global measures of uncertainty rose to a record high in 2018 while US measures remained subdued. As the US 2020 presidential election comes into view and discussion around taxation picks up, the dollar may start to attract more risk premium. More fundamentally, we would view higher tax rates as a negative for the dollar. Any shifts in US tax policy towards a more redistributive direction are likely to involve higher taxation on asset owners and the beneficiaries of the very low current levels of corporate taxation. This is likely to discourage US capital inflows as well as depress asset valuations. To the extent that tax policy shifts income from high to low income households it would also depress the US saving rate leading to a wider current account deficit.
Beyond these points, the money that goes into hedge funds and stocks in general tends to disproportionately come from lightly taxed wealthy Americans. If the political bandwagon for higher rates continues to gather steam, that will be a significant negative for U.S. assets over the next two years.
Sand in the wheels.
Other taxes are also back in vogue. With very little fanfare, Tuesday saw the introduction in Congress of a proposal for a “Tobin tax,” or a tax of 10 cents on every $100 of financial transactions. The idea gets its name from the Nobel laureate economist James Tobin of Yale University, who proposed the idea as a way to throw “sand in the wheels” of international finance. In principle, the idea is that it deters excessive speculation rather than raise revenue, and it tends to recur every generation. Most recently, the European Union floated the idea with great enthusiasm in 2011. To exhume something from the vaults, this video shows a discussion I had at the Financial Times with Jennifer Hughes on whether the idea can work. Unlike many others, I think a Tobin tax might be a great idea in principle — but it’s probably not workable.
To be clear, there is approximately zero chance that the latest proposal for a Tobin tax will become law in the U.S. while Republicans hold the Senate and the presidency. But it has every chance of becoming part of the agenda for next year’s election, and for obvious reasons it could be very market-negative. We should view this proposal as more of a fire-starter.
There is plenty of material on either side of the debate. This 2010 paper from the CME — which is not a great fan of throwing sand in the wheels of international finance — summarizes many of the criticisms. This 1999 paper from the AFL-CIO (much happier to throw sand in the wheels), argues that it could help efficiency. The debate continues. The important point is that the prospect of a Tobin tax might be more negative for markets than even the prospect of tariffs on U.S.-China trade. And like Chinese tariffs, a Tobin tax, if it gets traction, could yet have symbolic importance far beyond its practical impact.
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John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator. He is the author of “The Fearful Rise of Markets” and other books.
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