The Tax Man Cometh

Eugene O’Neill’s ‘The Iceman Cometh’ is a play whose cast consists of down and outers who gather at a Greenwich Village bar to drown their sorrows. Lies, con and even murder fill the plot. Fundamentally, ‘The Iceman’ is about self-deception, the desire to believe in something patently false, a willful defiance of reason and evidence.

Our belief systems require convenient narratives, ones that reassure and comfort, even if they don’t always fit fact or logic.

Today, the tax man cometh. It was bound to happen, sooner or later. Whether driven by the politics of fairness or the need to address gaping budget deficits, taxes are back in discussion, at least in the US. Inevitably, this topic will soon move to center stage in Europe and elsewhere.

For most economists, the Biden proposals appear to be convenient political narratives, rather than compelling solutions to deep-seated problems. Hiking capital gains taxes on 0.3% of the American population won’t make a dent in either the budget deficit or inequality. Higher taxes on the wealthy also won’t address carbon emissions or other sources of environmental degradation

Concerns on the right that the proposals will curb investment and productivity or will send investment abroad are homespun narratives, unsupported by evidence. Higher taxes on capital only marginally deter its formation. As John Maynard Keynes pointed out long ago, the key driver of business investment is ‘animal spirits’, not the cost of capital. If the economy performs, business will invest. Equally, there is little evidence that changes in personal tax rates, as opposed to corporate tax rates, leads to a global re-allocation of capital. 

So, the tax man cometh in predictable ways. From a macroeconomic perspective, today’s proposals are the banter at the bar amongst those who’ve had one too many drinks. At some point, a more serious debate will emerge about the merits of taxing carbon and consumption, and the need for revenues to be allocated more effectively to foster social cohesion via improvements in healthcare, education, training and livable communities. 

Still, a few remaining questions appear to loom large for investors. Chief among them is whether taxes on investment gains might produce a sell-off in capital markets. This deserves closer examination.

Market participants base decisions on probabilities. Hence, they must first assess the odds that US taxes on the gains of the well-to-do will go up and, if so, when and by how much.

Importantly, President Biden has gotten off to a fast and popular start in his first 100 days. A combination of fiscal stimulus, widespread vaccination and economic re-opening has boosted his approval ratings. Understandably, the more public support Biden garners, the greater probability that he can secure more legislative wins in Congress. Higher taxes have therefore become more likely than just a few months ago.

Still, getting the necessary votes won’t be easy. Facing almost certain 100% Republican opposition, Biden will have to secure every Democratic vote in the Senate and House to push through higher capital gains taxes on top US earners. 

That won’t be easy. 

Spending unites Democrats, taxes divide them. Moderate Democrats in suburban districts with pockets of affluent Americans may balk at Biden’s plans. The Democratic Party machinery is reliant on big donors ranging from Hollywood and Silicon Valley to Wall Street. The party establishment won’t be keen to tax the hand that feeds them. Congressional members from states with high income and property taxes –  such as California, New Jersey, New York or Connecticut – may withhold support if their concerns about SALT (state and local tax) deductions aren’t addressed. Yet SALT deductions are an anathema to progressives within the party.

Pulling together a majority of Democrats on taxes, even tax hikes that only impact 0.3% of Americans, will take coalition building. That means compromise. Which means that hikes in capital gains taxes or the end of step-up basis (which today zeros out capital gains on inheritance) probably won’t be as draconian as initially reported.

That’s a key reason why, after an initial fright, markets have held up.

Even if wealthy Americans have to pay higher rates on capital gains, selling pressures may be subdued. Wealthy Americans generally have access to liquidity or can borrow. They may prefer to hold out for a future administration to unwind any tax legislation passed this year. Taxes on inheritance can be minimized via gifting appreciated assets to younger generations. Charities may see a shift in donations from cash to pricey stocks and other assets that embed large gains.

Higher capital gains taxes will probably have bigger impacts on sectors and individual stocks than on the overall market. FAANG stocks might lag, for example. Some ‘tax washing’ may occur as well—sales in 2020 to take advantage of lower capital gains this year (assuming any legislation is not retroactive) followed by re-purchases. Some of that sales-purchase activity may favor the ‘rotation trade’, with investors shedding appreciated growth stocks and scooping up cheaper ‘value’ or ‘cyclical’ shares. The key point is that any sales are likely to be followed by fresh stock purchases. After all, in a world of super-low interest rates, investors have few alternatives to remaining invested in equities.

In short, today’s tizzy over the market implications of taxes is probably overdone. It is more about politics than substance. 

About the Authors

Larry Hatheway

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 recognized 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.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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