Tax Hikes & the Treasury Hedge -- The Capital Note

Illinois State Capitol in Springfield (benkrut/Getty Images Plus)

Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: Illinois’s proposed tax hikes, Treasuries lose their status as a hedge, and papal economics.

Illinois Tries More Taxes
I’m old enough to remember when one of the justifications for the near-elimination of the state and local deduction (a political and economic mistake in my view, and, yes, I live in Manhattan, don’t @ me) was that it would persuade some of the (searches thesaurus for euphemism) less financially disciplined states to move to a better funding model.

As a quick glance at some of what California has been planning of late makes clear that argument hasn’t (thus far) held up so well. And California is far from being the only example.

The Wall Street Journal focuses today, however, on Illinois:

Illinois is the nation’s leading fiscal basket case, with runaway pension liabilities and public-union control of Springfield. But it has had one saving grace: a flat-rate income tax that makes it harder for the political class to raise taxes. Now that last barrier to decline is in jeopardy on the November ballot.

The peril comes in a ballot measure backed by Democratic Gov. J.B. Pritzker and his party’s supermajority in the Legislature. A yes vote would amend the state constitution to replace the current 4.95% flat levy with a progressive rate structure on individual income. Gov. Pritzker, an heir to the Hyatt hotel fortune, is pitching this “Fair Tax” as a modest plea for more revenue from “wealthy people like me.” Hardly.

Democrats have announced a slate of new rates that will be imposed automatically if the measure passes. The current flat rate of 4.95% would rise to 7.75% for households earning above $250,000, with a top rate of 7.99% on incomes above $1 million. Proponents are also touting a planned tax cut for those making less than $250,000. But with a new bottom rate only 0.2 percentage point below the current one, taxpayers in that range can expect savings barely enough for an order of deep-dish pizza.

Mr. Pritzker says the economic slowdown requires raising more state revenue. But as the Prairie State’s own Barack Obama put it in 2011, “You don’t raise taxes in a recession.” Illinois’s unemployment rate in August was 10.9%, more than two points above the national average. The new tax scheme would further slow the jobs recovery by lifting the corporate tax rate to 7.99%, and by increasing the pass-through taxes paid by more than 100,000 small-business owners, according to the Illinois Policy Institute.

One of most interesting aspects of these proposals is the suggested move away from a flat tax. Apart from a flat tax’s simplicity and (to me) the virtue that its progressivity operates at only one level (wealthier taxpayers will still pay more tax, just not at a higher rate), it also comes with the advantage of ensuring that all taxpayers have at least some skin in the game, something that is appropriate both on grounds of (to use a much-abused term) ‘fairness,’ and because it increases the political cost of increasing that tax. Put another way, it provides an incentive only to increase taxes when truly necessary.

If, on the other hand, the bulk of the tax increase falls on a relatively narrow sliver of taxpayers, then the political cost of increasing that tax will be low, even more so if those hardest hit by the increase are more likely to be political opponents of those proposing the tax hike.

The Journal comments that “the state soon becomes beholden to affluent taxpayers for 40% to 50% of state tax revenue.” And that can come to mean the most affluent taxpayers of all. According to E.J. McMahon, senior fellow at the Empire Center for Public Policy, the top 1 per cent of earners pay 40 percent of New York’s income taxes and 47 percent of New York City’s income taxes.

That the longer-term consequences—wealthier people moving out of the state—may be economically damaging is a problem for another day, a problem made worse by the fact that ending the flat tax will increase the extent to Illinois is reliant on the rich, the category of taxpayer most able to flee, something that was true even before the increased possibilities of working from home that may become a permanent feature of the employment landscape after COVID-19.

The Journal adds:

Illinois led the nation in out-migration over the past decade, with its population declining in each of the past six years, according to the Census Bureau. A 2019 survey by NPR Illinois and the University of Illinois found that high taxes were the top reason respondents gave for leaving.

And there’s this:

This month Moody’s warned that [Illinois’] annual liabilities will exceed 45% of gross domestic product by 2021—the deepest fiscal hole in all 50 states. A progressive income tax would free lawmakers to shovel more money down that hole rather than address excessive government pensions.

What could go wrong?

— A.S.

Treasuries No Longer a Hedge
In the depths of the Covid sell-off, U.S. Treasury yields plummeted as investors fled from risk assets. That’s what’s supposed to happen when the world falls apart: Stocks, corporate bonds, and currencies decline, while risk-free U.S. government bonds do well.

But with Treasury yields at historic lows, investors are starting to question the ability of U.S. government debt to serve as a hedge against risk. Federal Reserve asset purchases have rendered demand for Treasuries virtually infinite, diminishing the effect of “risk-off” events on yields — one of the many ways that unconventional monetary policy is changing the landscape of global financial markets.

During crises, capital gains accrue to Treasuries on the expectation that the Fed will decrease interest rates, which makes the existing stock of bonds more valuable. But with interest rates at zero and Fed chairman Jay Powell ruling out negative rates, there’s little room for a further decline in yields.

In the midst of election uncertainty, asset managers now find themselves searching for alternative means of shielding themselves from volatility, reports the Financial Times:

Ahead of a potentially disputed result on November 3, fund managers are casting around for new harbours to shelter from a potential storm. Popular strategies include short-selling currencies that mirror stock movements; derivatives that provide insurance against falls; and emerging market bonds that offer a higher yielding, though riskier, hedge for equity holdings…

As investors look for hedges, those hedges get more expensive:

Investors have sought protection by snapping up insurance against equity market turbulence in the weeks surrounding the election, sending the price of futures contracts for the Vix volatility index — also known as Wall Street’s fear gauge — soaring. But the rising cost of such protection has added urgency to the search for alternatives.

The scarcity of hedges could mute the negative effects of election volatility. If avoiding downside in stocks requires complex, expensive currency derivatives, it might not be worth it. Some, I expect, will choose to go through November hanging on for dear life.

— D.T.

Around the Web
No deal on stimulus:

President Donald Trump told his negotiators to stop talks with Democratic leaders on a fiscal stimulus package, hours after Federal Reserve Chair Jerome Powell’s strongest call yet for greater spending to shore up the economic recovery.

“I have instructed my representatives to stop negotiating until after the election when, immediately after I win, we will pass a major Stimulus Bill that focuses on hardworking Americans and Small Business,” Trump said Tuesday in a tweet.

Stocks tumbled after Trump’s posting effectively called an end to months of hard-fought negotiations between the administration and Congress. Democrats had most recently pushed a $2.2 trillion package that failed to garner Republican support in the House, while the White House had endorsed $1.6 trillion.

Yield curve steepens going into November:

The US yield curve has steepened sharply as investors weigh the prospects of a Democratic victory in the upcoming US election and the potential of more aggressive fiscal policy.

On Tuesday, the yield on five-year Treasury notes traded 127 basis points below that of 30-year government bonds — the widest gap since 2016, save for a brief intraday move in June — after investors ditched ultra-long securities at a faster pace than their shorter-term counterparts.

Stock-market concentration slows economic growth:

The stock market should fund promising new firms, thereby breeding competition, innovation, and economic growth. However, using three decades of data from 47 countries, we show that concentrated stock markets dominated by a small number of very successful firms are associated with less efficient capital allocation, sluggish IPO and innovation activity, and slower economic growth. These findings are robust to alternative sample periods, econometric specifications, and competing explanatory variables. Our evidence is consistent with the paradox that the capital market of a competitive economy can impede the continuing competitiveness of that economy.

Random Walk
Before commenting yesterday on Pope Francis’ latest unimpressive foray into economics, I emphasized that the Capital Note was not a forum for theological debate — and it’s not. Nevertheless, it’s worth reading this piece from Matt Kilcoyne, the deputy director of London’s Adam Smith Institute in CapX today.

An extract:

The Pope, though, sees the individual in the modern world as someone buffeted by power, with no control over their own life, and at all too high a risk of exploitation. The free market, he argues, has ‘no place’ for those born into poverty, disability or without education and healthcare.

It is absurd to claim that advocates of free markets have abandoned these people. It is the market system that has provided more income, opportunity, and wealth than any other that has been tried. In the space of a few decades it has delivered billions out of the poverty he says they’re locked into. It has generated the wealth that means we can look after those that cannot work.

The Catholic Church, of which I have been a member since my childhood baptism, has a simple set of duties: the salvation of the immortal soul, the dispensation of the sacrament to the faithful, the spreading of the gospel, and caring for the poor, sick and destitute.

This document does none of these things, and actively diminishes the potential for the latter. Where the Pope declares that “if we make something our own, it is only to administer it for the good of all” he misunderstands the power of the words of Adam Smith that “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages”.

Smith is not describing the world as he wants it to be, like the Pope is, but observing the world as it is, and then using the advantage of that knowledge to provide as good an outcome to as many people as possible…

What is strange throughout this Papal polemic is that the Pontiff is open to the idea of the human as a social animal, but doesn’t get that trade and exchange are social relationships.

All told, this tired encyclical is a mish-mash of cliché and anti-capitalist diatribes we’ve become all too used to seeing in the West. Capitalism has seen investment and promoted individual interests, he argues, but it has “undermined the communitarian dimension of life”.

“There are markets where individuals become mere consumers or bystanders,” the Holy Father says. Yet consumers are not bystanders, by definition. They are actors, agents of change, who in their small and modest or big and powerful way, decide to mould the world.

Whether the contradictions contained within the Pope’s ideas are as “strange” as Kilcoyne politely suggests is a matter of debate. When it comes to economics and finance, Francis regularly reveals how deeply he has been influenced by the class-based demagoguery, economic illiteracy and conspiracism that characterized the Peronism of his youth. There’s no mystery there.

More importantly, though, Kilcoyne’s article is a reminder that, beyond simple utilitarianism, there are strong moral cases for the free market, of which he gives us one example.

— A.S.

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