A Looming Tax Shadow?

by | June 14, 2021

Bond yields are dipping. Relative to their peak levels in the spring, US ten-year Treasury yields have fallen some 30 basis points. That decline, however, has not been accompanied by a notable shift in the global economic fundamentals. Global growth surprises have not trended lower and, if anything, inflation has surprised on the upside. 

What might be behind the move in yields?

Central bank credibility is one factor. Resolute commitment to expansionary monetary policies is reflected in declining shorter and intermediate yields. Technical factors may also be at work. Falling yields have probably ‘squeezed’ the short positions of those investors who anticipated bond market weakness.

But perhaps the move also reflects a looming tax shadow. 

Might the prospect of higher corporate income taxes also be unnerving investors? At issue is the G7 agreement to pursue a minimum global income tax rate of 15% (GMT). 

The answer is two-part. First, the GMT itself is too small and too improbable to matter much for investors. But—and this is the second point—the agreement is also symbolically important, potentially heralding a long-term shift in priorities, one that could fundamentally alter asset returns. 

Investors appear to agree on the first point. If they harbored genuine fears that higher taxes would dent growth soon, equity indices would be falling. Instead, they continue to advance, with some at or near all-time highs. To be sure, the rotation trade from stable growers into more cyclical shares has paused, but relative returns between sectors and styles remain uneven and do not yet reflect a decisive reversal in market leadership.

Investors probably reckon, correctly we’d note, that the agreement brokered by US Treasury Secretary Yellen and endorsed by the G7 leaders faces difficult implementation challenges and won’t raise much revenue if enacted.

After all, the G7 countries are a long way from agreeing on the all-important details. Exact rules have to be worked out and mechanisms developed to enforce minimum tax rates. Basic definitions, such as what is meant by a 15% minimum rate, still have to be agreed upon. Countries that have benefitted from national tax competition, such as Ireland, have to be persuaded to cooperate. And, ultimately, buy-in is required from all countries.

But perhaps the biggest challenge will be passing domestic legislation to make it all possible. In the US, the Biden Administration faces strong Republican opposition. Given a chance to tinker with the tax code, Democrats may split over a range of tax issues that divide the party.

And even if the political stars align, a minimum global corporate income tax won’t be all that significant in economic or fiscal policy terms. The global minimum rate is close to where global effective tax rates reside. Tech giants may pay more, but many companies won’t be significantly affected. Also, total corporate taxes account for less than 10% of most countries’ fiscal revenues and less than 4% of rich country GDP. For G7 countries, where government’s share in GDP is 25-40%, the revenues raised from the proposal are likely to be small. And that means that the impact on aggregate demand will be small. The global recovery is hardly at risk from a 15% GMT. 

It is unlikely that higher corporate tax rates, alone, will materially slow business investment spending and dampen long-term economic growth rates. Taxes on capital, unless excessive, have only marginal impacts on capital spending. A 52% corporate income tax rate during the 1950s did not deter strong US business investment nor surging postwar productivity. The same was true during the 1990s productivity burst, when the government’s take of corporate taxes was 35%. Keynes put it best—animal spirits, not the marginal cost of capital—drive business investment spending.

But even if politics and economics suggest investors have little to fear in the near term from the GMT, its’ discussion has broader symbolic meaning, with potentially large implications for businesses and capital markets. It is, for example, the first post-pandemic step in an inevitable push by governments to raise revenues. Yawning budget deficits, unprecedented inequality and a legacy underinvestment in public goods demand that governments find significant sources of funds in the coming decade to meet social and economic needs. 

The political will to restore faith in the fairness of the tax code is also strong. In that regard, the GMT heralds a secular shift towards more progressive tax structures, including higher corporate tax revenues. After-tax profit margins face secular headwinds.

Global tax agreements also represent a return to multilateralism. For some, that is an unalloyed plus. Others may fret that GMT opens the door to international harmonization of social, environmental, labor and regulatory policies. Populism comes in many forms, and its next manifestation may aim to curb corporate globalism. Companies that have profited from global regulatory, environmental or labor ‘arbitrage’ may see those avenues pinched off in the years to come.

Finally, picking winners and losers on the basis of tax law is a challenge. Changes in the tax code are often more about the fine print than the headline rate. For instance, in the 2017 Tax Cuts and Jobs Act, which lowered the statutory US corporate income tax rate from 35% to 21%, capital intensive industries, such as utilities or transportation, benefitted from generous equipment expensing provisions. Given the prevailing political sentiment today, the next round of winners could include ‘green’ companies and those that choose to move overseas production back home.

In short, harmonizing minimum rates of corporate income tax has global momentum. But it isn’t likely to have immediate impacts on growth, budget deficits and markets because the size of the measures under consideration is modest and because enacting legislation will be politically difficult. Still, behind the details of the GMT reside broader political, social, public finance and economic agendas whose secular impacts on markets could be profound. Investors ignore the trend at their peril.

About the Author

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy.

Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland.

From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT.

At both GAM Investments and UBS Investment Bank Larry was widely recognised for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others.

Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

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