Rep. Charles Rangel (D-NY) made some tantalizing comments yesterday in a CNBC interview, saying that Treasury Secretary Paulson had convinced him that lowering the U.S. corporate tax rate to 25% might be a good idea. On its face, this is very bullish news, although questions and qualifications apply. For example, is this enough to make the U.S. economy competitive for the long term? Or is it just enough to maintain the competitive status quo for the time being? Will it be hamstrung by so-called ‘paygo’ rules that simply shift the burden onto productive activity elsewhere? Or will it be based on analyses of the dynamic, behavioral effects of shifts in incentives, and their impact on future productivity?
On a minor note (one that’s of interest to our little firm), will it do away with or simply rearrange the current incentives and distortions regarding forms of corporate organization? For example, income of certain entities such as LLCs is typically deemed to ‘pass through’ to its owners, where it is taxed at their personal rates. If the LLC owners are successful, a maximum tax rate of 25% tax becomes much more attractive–especially if top marginal tax rates on personal incomes are pushed higher in order to ‘pay’ for a lower corporate rate (some estimates run as high as a 40% top marginal income tax rate). Among the many effects, this would be yet another ’make work’ gift to the legal and accounting professions from Congress. And if cost-effective options for business formation aren’t left on the books for small business owners, it could be quite harmful to labor markets, incomes, tax revenues, etc.
Of course, a serious problem remains in the corporate tax codes, which is the double taxation of profits on public companies (profits are taxed first the corporate income tax return, and again as shareholder dividends and capital gains). In fact, if Congress were to leave the capital gains and dividend rate of 15% untouched–something many Democrats are loathe to do–then a single 25% corporate tax rate can end up at 40% under many scenarios.
That mathematical exercise begs the question–is Rangel seeking a way to level a 40% tax on the most productive economic activity in the U.S. economy? If so, the Mother of All Reforms wouldn’t be so bullish after all. That probably would mean an easier Fed policy would be required to support the domestic economy, and in the context of a white hot global economy, that in turn means continued stagflation here at home–although there’s still nothing in sight at the level of the 1970s stagflation, when the tax code and high inflation imposed a required return on capital in excess of 100%!!!
Here’s a fascinating ‘Whodunit?’ from SmartMoney columnist and financial commentator Don Luskin:
Now it can be told! Twenty years after the great stock market crash of October 19, 1987, when the Dow Jones Industrial Average fell by more than 22% in a single day, the truth about why it happened can now be revealed.
And believe me, I know what really happened. Because I caused the crash myself. Yep, it was me. With a little help from my some bad judgment, some colossal mistakes, and some outright criminality.
Back then I ran portfolio management and trading for Wells Fargo Investment Advisors. With $69 billion under management, we were then the world’s largest institutional investment manager. The company is now called Barclays Global Investors, and with almost $2 trillion under management, it’s still the world’s largest.
In 1987 Wells Fargo was by far the largest player in the two strategies that caused the crash. One was "program trading," the simultaneous execution of hundreds of stock trades with a single electronic order. The other was "portfolio insurance," a hedging strategy that used program trading and stock index futures to hedge the downside risk in institutional stock portfolios.
According to official government reports issued in the aftermath of the crash, program trading and portfolio insurance combined to cause the crash. The portfolio insurance strategy required that Wells Fargo execute program trades, selling all 500 stocks in the S&P 500, over and over as the market declined. With every execution, the market declined even more. And that triggered the next execution.
…On the day of the crash, we were executing plenty of sell programs for our own portfolio insurance strategies all day. At the same time, clients called to say, "Sell a billion S&P, right now" — and we did. Then they called again. And we sold again. And again.
That’s why I say I caused the crash. It was my team’s finger that was on the sell button. It was our job to push it, and we pushed it.
Our execution of portfolio insurance and program trading strategies were blamed for the crash in the official government reports. But here’s what got left out…
You’ll have to read on for the detective element of the story. It will be posted on his SmartMoney column later today, and is available at his personal blog this morning.
This issue might not make sense to those outside of the investment management industry, but it’s a very important development for our profession. According to Lisa Scherzer at SmartMoney.com, the California Public Employees Retirement System (CALPERS), an 800 pound gorilla among U.S institutional investors, is considering a new type of fee schedule for active investment managers that will compensate for alpha production only (alpha production can be thought of as returns in excess of a specified benchmark, which is usually a comparable security market index).
This is an important issue in our view for many reasons, reasons that can be summarized generally into the principle of alignment/misalignment of investment managers’ and clients’ interests. Traditional forms of manager compensation (and others’) are sometimes unfavorable to investors. This belief is one of the factors behind our choice of the word ‘symmetry’ in our firm’s title, and is meant to convey a more balanced sharing of risks and returns between managers and clients. But a closer alignment of interests will require some courageous, outside-the-box thinking among industry practitioners and (importantly) their regulators. With its recent announcement, CALPERS appears to be treading a path in that direction–on behalf of pensions and their beneficiaries, at the very least.
We came across economist Gary Becker’s summary of the recent IMF study on globalization and inequality, which we also ruminated on recently. Here are some of his most salient insights:
…a careful evaluation of the report’s findings on income and inequality provides in most respects an optimistic assessment of the effects of globalization on developing nations…
…The report’s evidence quite strongly supports this building block of trade theory: greater trade…[decreases] earnings inequality within developing countries…
…The IMF report clearly shows that generally the poorer and less educated in developing nations also became better off…This improvement in wellbeing at the lower end of the income distribution surely should count as a benefit of globalization.
The increased earnings gap…[with]in developing countries reflects that the earnings of more educated individuals rose faster than the earnings of the less educated…[which] essentially means that the returns on investments in schooling increased.
…how can one complain that globalization is bad because it raises the returns on the education of local human capital investors? Higher returns to human capital investments…mean that the economy is more productive, which should be a welcome development to poorer as well as richer countries.
…developing countries in which the criticisms are strongest are generally countries that have done a bad job of educating its [sic] population…The lesson…is that globalization is not the source of these serious problems. Rather…many developing countries have to do much more to open up access to better and greater education for children coming from lower income families. Only then would these families be able to take advantage of the higher returns to education produced by greater trade and the inflow into their economies of modern technologies and foreign capital.
Richard Posner, Becker’s blogging partner, also offers some interesting thoughts on the study and the larger issues it raised.
Today we came across a very solid analysis from 2006 by labor economist Stephen Rose, in which he challenges a widespread belief among Democrats and the political left that a majority of Americans who vote for Republican candidates do so against their interests. In my experience, categorizing mass human behavior as irrational is the first resort of those who find the outcome of those behaviors personally disagreeable. Thus, we are big fans of critical analyses that dispel convenient untruths, whatever their political stripe.
On an interesting side note, in the wake of his Nobel Peace Prize, bids on Al Gore to win the Democratic nomination have pulled even with those on Sen. Obama, at around 11% each. However, at this point, these are call option bids only, as Senator Clinton’s chances have jumped from 40% to 70% since August–both are likely to expire worthless, barring any major surprises. The Gore Vice President contract is a peculiar example of inefficiency today, trading at 17 times the volume of the other Dem VP contracts while sporting the widest bid ask spread among the top four candidates! Perhaps this relative lack of information shouldn’t be surprising, since the VP nominee typically depends upon a prior probabilistic outcome (ie, the Presidential nominee). If true, we’d expect the VP contracts to "tighten up" once some of the state primaries are settled.
Also interesting among Dem VP candidates is that the probabilities of a Clinton-Obama ticket and a Clinton-Richards ticket have dropped (too bad, we like Gov. Richards), while Evan Bayh’s chances have increased to around 15%. The highest probability is still placed on Obama however, at 22%, so the ticket-of-historic-proportions theme is still intact.
Not as much intrigue on the GOP side, though Fred Thompson’s chances have fallen since officially entering the fray, and markets are saying that no one seems to know who the presumptive VP candidate will be–the ‘Field’ contract (synonym for ‘Other’ or ‘None of the Above’) leads all named candidates by a wide margin–30% to Mike Huckabee’s 16%.
10/19/2007 — The speculation around Al Gore has largely been dispelled; here’s an example from Lynn Sweet of the Chicago Sun Times.
A great deal of attention was paid to the IMF’s most recent survey of globalization and inequality, specifically to the growing disparity it revealed between the world’s richest and poorest. However, there are two important findings within the study that, in our opinion, deserve more attention than they received.
First is that "per capita incomes have risen for all income groups in all regions" (see chart 4). While the perceptions and realities of the ’income gap’ are important, judging by primate studies and human history, it is still important to acknowledge that all income groups are at least nominally better off in material terms during the period studied. Policy measures aimed at narrowing the gap could have the unintended effect of undermining the overall rate of income growth.
Second, and of the utmost importance, is that the biggest contributor to inequality (see chart 7) is not global trade and financial integration, but technological progress! What does this imply? To us, it signifies that investment is the key driver of rising incomes, and that lagging income growth is therefore a symptom of lagging investment. Where does investment tend to lag? In regions and countries where factors such as property rights, tax burdens, human capital, et cetera are poor and uncertain.
Thus, contrary to popular interpretations, the growing gap between richest and poorest may not be caused by greed among the well heeled, but by poor governance in the neediest regions of the world.
FT columnist Wolfgang Munchau places blame for the recent credit market turmoil squarely on central bank policies of a few years ago:
…to blame ratings agencies is like blaming shopkeepers for inflation. If you look for an underlying cause of this credit bubble, one of the biggest of all time, then surely you are looking at something bigger than a couple of ratings agencies. I believe that the explosive growth in credit derivatives and collateralised debt obligations between 2004 and 2006 was caused by global monetary policy between 2002 and 2004. In parts of 2002-04, both the US and Europe experienced negative real interest rates – nominal rates adjusted for expectations of future inflation…A negative real interest rate is…a troubling concept. It means that those who have access to credit at that rate – in this case commercial banks – have an interest in borrowing an infinite amount. Individuals and companies generally borrow at higher rates but the closer a real interest rate gets to zero, the greater the incentives become for people to take on large amounts of debt. In a world of perfect credit markets, one would expect negative real interest rates over a long period to cause a credit bubble. Oddly, economists seem perplexed by the fact that something that was supposed to occur in theory actually happened in practice…
Munchau makes the argument that an increasingly well developed financial system makes credit more widely available, and that credit activity and asset prices should therefore be taken into account by central banks in addition to price indices.
…..it is time to learn the main lesson of this crisis, which is that credit matters for monetary policy, a fact over which many central bankers are still in denial.
Here’s an interesting clip from CNBC Europe re tax changes proposed to Parliament by Alistair Darling, UK Chancellor of the Exchequer, described as an attempt to close loopholes and recapture political momentum on tax issues from conservative politicians. At first blush, the new rate does not seem too draconian at a unified 18% for realized short and long term gains (the breakpoint is two years under current law). However, the current long term rate is 10%, and there is no indexing for inflation. Thus it increases the tax penalty by 80% on those entrepreneurs and investors who ‘do the right thing’ by taking longer term interests in the business ventures they own.
Bill Dodwell of Deloitte & Touche is the CNBC interview subject, and he describes the potentially negative impact on marginal entrepreneurial investment, and by extension, the British economy:
Britain needs to encourage [entrepreneurs] and a lower rate would send the right signal…It is really bad to hit entrepreneurs, but nonetheless the Treasury has gone with it. I would hope in years to come they would rethink that particular policy…
Today’s WSJ ran an op-ed (subscription required) by Christopher DeMuth, president of right-leaning think tank The American Enterprise Institute, or AEI. Mr. DeMuth offers several insights into what makes a think tank successful, but most interesting was an opaque prediction regarding corporate tax rates under a President Hillary Clinton:
"…I predict that if Sen. Clinton is elected president the corporate income tax will be furthr reduced during her tenure."
There are no clues in the article that would explain this prediction. But a lower corporate tax burden–as the inimitable Martha Stewart might say–would be a good thing.
Columbia Professor and "globalization guru" Jagdish Bhagwati has penned an interesting social and historic critique of anti-globalization since the late 1980s, concluding that support for "free trade is alive and well among economists."