Oliver Wendell Holmes famously said that “Taxes are the price we pay for a civilized society.” We agree wholeheartedly, and as investors we watch the political landscape surrounding the U.S. tax regime closely because of its short- and long-term impact on economic growth. Taxes, like death, may be unavoidable, but the shape of the tax code has a deep influence on the economic fortunes not just of individuals but of the country as a whole.
Presidential Tax Proposals
President Obama’s budget for fiscal 2016 showed the direction he is pursuing in tax policy. Congressional resistance means he will likely to be able to implement few if any of his proposals, but it’s important to see where the emphasis is.
The budget shows a mixed picture, leaning heavily towards increased taxes for upper-income earners:
- Higher-bracket earners would receive less benefit from claimed deductions;
- The “Buffett Rule” would set a minimum effective tax rate of 30% for top earners;
- Estate taxes would return to 2009 levels;
- Capital gains taxes would rise for top earners;
- Many assets inherited by heirs would now pay taxes on the appreciated (current fair-market) value of those assets, as if they had sold them and realized the gains.
The last has attracted particular comment, because even with its accompanying hedges and exclusions, it could often force the sale of assets (such as family business) to meet tax obligations at an owner’s death.
There are also breaks for lower-income earners, including a new “second-earner” credit for some families where both members of a couple work, as well as dramatically expanded credit for childcare expenses for most families.
Finally, the President proposed a revamping of corporate tax policy to impose a one-time tax on corporate profits held abroad, and moving forward, implement a hybrid global tax system which would tax corporate income earned abroad at 19 percent. The immediate bolus of $240 billion (from the estimated $2 trillion U.S. corporations are believed to have overseas) would be dedicated to U.S. infrastructure investment -- sorely needed, to be sure, but an area where as we know, corruption and inefficiency can be rife.
The Big Picture of the President’s Program
In our view, there are two basic approaches to encouraging the prosperity of middle America. The first is to tilt taxation more heavily to upper-income earners, and use the proceeds for Federal expenditures that will benefit a broader public. The second is to encourage economic growth by enabling and incentivizing capital formation by successful investors and businesspeople -- such capital formation being the ultimate foundation of growth, prosperity, and job creation. Most of the political battles around taxation simply reflect the relative weight given to each of these concerns.
Mr. Obama falls securely in the first camp, and his FY2016 budget is a straightforward attempt to implement that vision.
In our opinion, global trends argue against him. For many of the President’s co-travelers, Europe stands as an example of the “social democratic” state they would like to see, and which the U.S. also has been incrementally approaching over the past 50 years. But Europe’s sluggish growth and high unemployment seem directly related to the heavy burden of regulation and taxation that is entailed by the social democratic vision of distributed prosperity. Germany’s 2010 reforms under Gerhard Schroeder set that country on a more dynamic economic path, and it is currently the brightest spot in Europe (along with some smaller northern European economies that have gone the same way).
We believe that too strong a tilt to redistribution impairs capital formation and dynamic business growth, and ultimately slows GDP growth and reduces prosperity for the average wage-earner. If we saw the U.S. progress decisively and universally in a social democratic direction, it would make us incrementally less optimistic about prospects for longer-term U.S. growth. We believe this thesis is borne out by simple historical observation.
State Governors Follow a Different Path
However, the current Federal tilt is only one of two forces operating in the United States. Contrary to the direction of Federal policy, many state governments are acting to restructure their tax systems in a way that will incentivize business development and capital formation.
Nine states have no taxes on wages and salaries, and others are set to join them. It’s a goal of Arizona’s new governor, and governors in Maine, Arkansas, Illinois, Maryland, and Massachusetts are also seeking to reduce income taxes. These governors view the issue simply as one of competition. Arizona’s governor says, “We want those jobs and companies that have been headed to no-income-tax states like Florida and Texas to start coming here at a faster pace.” Various academic studies suggest that this practical concern is well-founded, with higher state income taxes correlated with slower job growth.
Red states have no income taxes; yellow states tax only dividend and interest income.
Detractors argue that in these states, the tax burden is not eliminated, but is simply shifted to other areas that mostly hit lower-income workers harder. Tennessee, for example, has no income tax, but the highest combined state-and-local sales tax in the country. That, they say, is regressive.
What detractors fail to see, however, is the bigger picture.
Income-tax-skeptical governors are picking up on the other side of the problem that we mentioned above: that the best way to improve the prosperity of the middle class is to incentivize businesses to create jobs. In order for that to happen, capital formation must be incentivized -- and in order for that to happen, income taxes must be incrementally lowered.
We believe that the states following this agenda will continue to attract new and relocating businesses, and will continue to outstrip their competitor states in job creation.
Two Sides At Loggerheads
Which tendency will win out? We don’t know, but the conflict suggests a continuing tug-of-war between the Federal authorities pursuing one path, and state officials (and perhaps Congress) pulling in the other direction. We would not be surprised if we continued to see outperformance by low-tax states in job creation. Ultimately, though, state-level effects are not likely to overcome the influence of Federal policy.
Investment implications: The long-term color of our sentiment for the U.S. is influenced by trends in tax policy, both state and Federal. We will become incrementally less bullish on U.S. growth longer-term if the overall trend of tax policy disincentivizes capital formation and small business growth and more bullish if taxes are lowered to incentivize capital formation and job growth.
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