Friday, February 22, 2013 - Taxes, Sequester, Inequality, Name That Stadium

Note: I will be speaking at the 2013 Wealth Protection Conference on April 5th and 6th. For information, click here

Taxes, Sequester, Inequality, Name That Stadium

by Sinclair Noe

DOW + 119 = 14,000
SPX + 13 = 1515
NAS + 30 = 3161
10 YR YLD - .01 = 1.97%
OIL + .52 = 93.36
GOLD + 4.50 = 1582.50
SILV + .08 = 28.86

The European Commission has released its forecast for this year for Euro-zone economic growth, or lack thereof. The economy is expected to shrink in back to back year for the first time, driving unemployment higher, and spending will likely be lower for governments, consumers, and companies. Gross domestic product in the 17-nation region will fall 0.3% this year, compared with a November prediction of 0.1% growth. Unemployment will climb to 12.2%, up from the previous estimate of 11.8%.  The commission’s weak outlook reflects government austerity measures and efforts by companies and consumers to reduce debt. Seven Euro-zone economies are expected to contract in 2013, including: Italy, Spain, Portugal, Greece, Cyprus, Slovenia, and the Netherlands. Germany is expected to show modest growth of 0.5%, revised down from earlier estimates.

One of the things the Europeans are considering is a tax on financial trading; it will likely go into effect as soon as next year. The traders claim a tax would hurt economic growth and raise the cost of capital for companies, and they claim it would drive trading to other countries, leaving the country that adopted it with less revenue and fewer jobs. But those arguments have not proved persuasive in Europe, which thinks it has found a way to keep institutions from avoiding the tax.

The tax would be tiny for investors who buy and hold, but could prove to be significant for traders who place millions of orders a day. Under the proposal,  a trade of shares worth 10,000 euros would face a tax of one-tenth of 1 percent, or 10 euros. A trade of a derivative would face a tax of one-hundredth of 1 percent. But that tax would be applied to the notional value, which can be very large relative to the cost of the derivative. So a credit-default swap on 1 million euros of debt would have a tax of 100 euros, or about 0.4 percent of the annual premium on such a swap.

The tax would be far smaller than the fixed commissions that American investors once took for granted, and even less than the costs implicit in the fact that until decimalization arrived in 2001, that most stocks could move only in increments of one-eighth of a dollar, or 12.5 cents.

So, the tax isn't likely to destroy markets, however it will probably slow down high frequency traders and some hedge fund trading. In those circumstances, traders typically trade with highly leveraged funds on very narrow margins; it's a great strategy when it works; it's a huge disaster when it doesn't work.

But, what's to prevent investors from just trading in other jurisdictions? The tax would be owed no matter where the trade took place, as long as a European security or European institution was involved. The law has been written so broadly that if a French bank bought shares in an American company on the New York Stock Exchange, the tax would be owed. The Europeans call it a Triple A approach: all markets, all actors and all products.

To get out of the tax, a financial institution would have to do more than simply move its headquarters out of the 11 countries that now plan to impose the tax. It would also have to forgo serving clients in any of those countries and trading in securities or derivatives from any of the countries. Officials are confident that no major institution will be willing to forsake such large markets as France, Germany, Italy and Spain.

The scope of the tax is very broad. The proposal has exceptions for currency trading and the physical trading of commodities, but not for derivatives like currency or commodity futures contracts. When a company sold newly issued securities to investors, that transaction would not be taxed, but subsequent market trades would be. Over-the-counter trades would be subject to tax just as would transactions on a stock exchange, as long as a financial institution was involved. You could sell your shares in Daimler to a friend without paying tax, but not if you got a broker involved.

Europe thinks it can bring in 31 billion euros, about $41 billion at current exchange rates, from the tax. The United States presumably could collect more if it adopted a similar tax. A secondary benefit of the tax is something the Euro-Commission describes as “creating appropriate disincentives for transactions that do not enhance the efficiency of financial markets”; in other words, it will be tougher on gamblers and reckless speculation. Will it work? We'll find out.

Italians will cast ballots on Sunday and Monday for a new government. The likely winner is the center-left candidate, Pier Luigi Bersani, but there is a very good chance he won't get enough votes to actually form a government. Bersani may be forced into a coalition governmment involving Mario Monti, the technocrat who served as temporary PM following Berlusconi's resignation. The other candidates include former Prime Minister Silvio Berlusconi, (who just won't go away) representing the right, and a comedian named Beppe Grillo, representing left field.

I mention the Italian elections, not because I have great insight into Italian politics, nor do I think it represents a make or break moment for the European Union, although it certainly has the potential to reignite the euor-zone crisis and affect the world economy. Rather I bring it to your attention in the hope that, by way of comparison, the Washington political situation isn't a complete mess....

Nah.

It's a mess, and that mess will be on full display next week as we head to the finish line for sequestration. The quick recap is  that there was a budget stalemate in the summer of 2011. A “super committee” of Democrats and Republicans were unable to agree to a large-scale deficit reduction package and as a result both parties signed off on the Budget Control Act, which slashed domestic and military spending by $1 trillion over the next decade. The deal between the two parties was designed to force them to come to the negotiating table again to avoid these draconian measures but both sides have been shockingly partisan and uncompromising. It appears unlikely there will be consensus by next Friday.

If the sequester takes effect as planned, employee furloughs in the Defense Department as well as air traffic controllers, meat inspectors and other government workers could begin in April. It is not a doomsday scenario but it is going to be tough because there are other factors at play.  If the sequester takes effect as planned, employee furloughs in the Defense Department as well as air traffic controllers, meat inspectors and other government workers could begin in April.  The Payroll Tax Holiday ended with the fiscal cliff deal; and that means 2% less from paychecks. Toss in a one month 47 cent per gallon jump in gas prices. Don't forget that stock prices have bumped their hats on resistance. And the Federal Reserve's printing press is already running full  speed. You don't have to turn bearish, but this is not the time for complacency.

One of the most frightening things this past week was the FOMC minutes, wherein at least a few Federal Reserve policymakers actually started believing their own PR, and started to subscribe to the notion that the markets reflect fundamentals, and they actually believe that the strength of the markets reflects an improving economy. And an improving economy doesn't need the Federal Reserve's printing press running at full speed, so some of them want to shut down the printing press, which is the lifeblood of the markets.

During the debate over the sequester, Democrats and the Obama administration have repeatedly called for closing loopholes in the tax code that disproportionally benefit the wealthy in lieu of drastic cuts to each and every sector of government. Republicans have continued to back spending cuts, and have indicated that they are generally opposed to tax increases, except maybe, very specific tax increases, but nothing big.  The backdrop for this debate is income inequality. There is a way to measure income inequality; it's the Gini ratio, which measures the gap between the rich and the poor. The US ranks 41st out of 136 countries for inequality and we have the 4th highest inequality levels of 34 so-called developed nations. Income inequality is a problem. The question is, why?

Republicans have argued big government, taxation and regulations are restricting small business owners from moving up to a higher income bracket. They have proposed cutting the size of government to enable small business owners to flourish. 

Democrats have argued that the income disparity comes from low wages and privileges granted to the wealthy in the form of low capital gains taxes on investment incomes and on other tax loopholes.  They have proposed increasing the minimum wage and raising the capital gains rate.

Thomas Hungerford of the non-partisan Congressional Research Service has published a report that says income inequality is largely derived from changes in the way the government taxes income from capital gains and dividends.

This study found that the wealthy benefited from low tax rates on investment income, which in turn caused their wealth to grow faster. Wages, interest, and taxes have contributed to a lowering of income inequality. Business income and retirement income have contributed to an increase in income inequality. Capital gains and dividends have contributed more to the rise of income inequality than everything else put together.

Essentially, taxing capital gains as ordinary income would make the playing field more fair, and reduce over time income inequality. Such a tax would serve as a deficit reduction measure that could replace portions of the sequester. Of course the next question is whether a higher capital gains tax would hurt the economy and growth prospects. There is very little evidence to suggest higher capital gains rates have any effect on economic growth. There simply is no empirical evidence that investment levels increase when capital gains rates are reduced, nor is there indication that investment levels decrease when capital gains are increased.

And I want to mention a story that actually appeared earlier in the week.  I don't know why I waited; maybe I was incredulous; maybe I was concerned it was one of those Chuck Hagel speaking gigs with Friends of Hamas – type stories. But this one is real. It involves the naming rights to the football stadium for Florida Atlantic University, which I had never heard of. For $6 million, the stadium will henceforth be known as the GEO Group Stadium. GEO Group is a private prison corporation.  The FAU team mascot is an owl, and already, the students have nicknamed the stadium “owlcatraz”.

 The United States penitentiary-industrial complex imprisons one-third to one-half of all incarcerated individuals in the world. Additionally, it has been reported that one of every three US individuals have some sort of interaction with the criminal justice system before they are 25. While there are some six million behind bars – often for penalties of 25 years or more – these figures do not include people on parole and others who are out of the formal system but still suffer the consequences of being behind bars.

I understand naming rights; it's a form of advertising. The KFC Yum! Center hopes to sell more Pepsi's and chicken. The University of Phoenix Stadium which is actually located in Glendale, hopes to draw attention to the online University which doesn't have an actual football team.  And don't forget Enron Field. 

GEO Group reported revenues in excess of $1.6 billion in 2011, income generated mostly from state and federal prisons and detention centers for illegal immigrants. The company owns or runs more than 100 properties that operate more than 73,000 beds. And they are not just a private prison corporation, they a a bad private prison. Specifically there have been accusations and GEO has lost lawsuits regarding unnecessary deaths of people in their custody, pervasive levels of staff sexual misconduct, cruelty and abuse of children held in custody, and really disgusting and filthy conditions that would make Carnival Cruise lines blush, and more.

So, why would GEO need to advertise its brand? Is this supposed to make us want to embrace for profit incarceration? The single purpose of a private prison corporation is to deliver the highest possible revenue stream at the lowest possible cost. Justice is not part of that equation. Rehabilitation and deterrence are not part of the profit equation.

I will now try to save you three hours on Sunday evening. It is not necessary to sit through the tediously boring Oscar show to find the winners. Nate Silver, the statistician who runs FiveThirtyEight, and who accurately predicted the November elections; like 100% accuracy; Silver has come out with the statistical probabilities of who will win Oscars. I should warn you that he is better at predicting elections than Oscar winners, but he has a 75% accuracy rate on the Oscars. The methodology involves looking at the other awards programs, such as the Screen Actors Guild, the Golden Globe, and then weighting to awards that have frequently corresponded with the Oscar winners in the past, and which are voted on by people who will also vote for the Oscars.

Best Actor to Daniel Day-Lewis for Lincoln. Best Actress for Jennifer Lawrence in Silver Linings Playboook. Tommy Lee Jones for Best Supporting Actor in Lincoln. Best Supporting Actress goes to Anne Hathaway for Les Miserables. The Best Director goes to Spielberg for Lincoln. The Best Picture goes to Argo.