the border tax

too-high corporate tax rate

The rate at which the domestic earnings of US corporations are taxed by the federal government is unusually high by world standards.

Corporate response has been what one would expect:  some firms leave for lower-tax jurisdictions; others engage in elaborate tax avoidance schemes, the bare bones of which I wrote about yesterday; still others spend tons of time and money lobbying Congress for exemptions.  Not a pretty picture.

What to do?

The straightforward answer would be to lower the tax rate and eliminate the special treatment.  Of course, congressmen, lobbyists and the industries receiving tax breaks are all against the latter.

border tax

That’s one reason for the appeal of a flat tax of perhaps 20% on the value of all imports–it leaves the status quo untouched but raises tax dollars to offset those lost through reducing rates.

A border tax would have another advantage, eliminating abuses from transfer pricing.  This is a practice whereby goods imported into the US are first shunted on paper through a tax haven where their price is raised.  The effect is to redirect profits from the US to the tax shelter country.

problems

The biggest theoretical issue with a border tax is the law of comparative advantage, the idea on which most international commerce is based that countries all gain by specializing in what they do best and buying everything else from abroad.  Contrary to what one might think at first, trying to do everything in-country and taxing imports reduces national wealth.

A big practical defect of the border tax, to my mind, is that there are mammoth categories of everyday goods–food, clothing, furniture, toys–that are only available at low cost in the US because they are made abroad.  Another is the question of retaliation, as the US is now doing against Canadian efforts to favor local milk products over imports from Wisconsin.

a rising dollar?

Border taxers reply to the higher-cost-of-imports issue by claiming that implementing a border tax will cause the dollar to rise–maybe even by enough to offset the effects of the border tax in dollar terms.  How so?

The argument is that every day US parties go into the currency markets wanting to exchange dollars for foreign currency.  Similarly, foreigners come with their currency to exchange into dollars to buy US-made stuff.  The interaction of supply and demand sets the exchange rate.

Post border tax, higher prices of foreign goods means less demand in the US for them, which means fewer dollars available for exchange, which means the price of dollars goes up. Some border tax advocates claim the dollar spike could be as much as +25%-30%.

huh?

I suppose this line of reasoning could be right. But it seems to assume, among othe things, that, contrary to what we’re doing with Canada, no one retaliates; and that demand for now-higher-priced US goods remains relatively unaffected.  Good luck with that.

Ultimately, though, I think that, whatever the strength of its conceptual underpinnings, the border tax is an attempt to avoid attacking the rats nest of special interest exemptions in the tax code while still lowering the headline rate. So it’s “fixing” one tax distortion by creating another.  That’s vintage Washington.  But making taxes more complex, not less, is a recipe for trouble.

 

 

the Trump tax plan

President Trump has submitted the outline of his income tax plan, reportedly in bullet points on a single sheet of paper, to Congress.  Although some have derided the lack of detail provided, the submission at least makes it very clear what is going on–and will likely help underscore the allegiance to special interests that opponents to what I considr a no-brainer tax fix may be serving.

On the corporate side, the reduction of the top rate to 15% will address three very important tax issues, all spawned by the fact that US corporate income tax (for those unable to cut a sweetheart deal) is higher than just about any other place on earth.  The current problem areas I see them are three:

inversions, where a company paying full freight in the US reincorporates on paper, usually through a merger with a foreign firm, in a low-tax country like Ireland (where the tax rate is in the low teens).  Pharmaceutical companies, which have few ways of reducing their taxable income, have been the most prominent group doing this.  At the stroke of a pen, their after-tax income goes up by 30%.

transfer pricing, a long-time standby of multinationals.  That’s where goods made by a third party in, say, China and destined for ultimate sale in the US are bought for, say, $10 each by the on-paper subsidiary of a US firm.  The goods are marked up by Hong Kong to $20 and sold for that to the US parent.  Since foreign firms doing business in Hong Kong pay no corporate tax, that $10 markup, which probably remains in a bank in Hong Kong, allows the parent to avoid paying $3.50 or so in tax to the IRS.

intellectual property transfer, a variation on transfer pricing.  A US firm transfers its patents, ownership of its brand name… to a subsidiary in a low-tax jurisdiction.  Ireland is a favorite destination.  It pays royalties to the subsidiary for the use of the intellectual property, generating an expense that reduces US income otherwise taxed at 35%, while paying less than half that to the country where the intellectual property is now domiciled.

One major effect of these strategies is that all of the cash saved is trapped abroad.  This is because IRS regulations require corporations repatriating such foreign income to pay tax on the transfers equal to the difference between the US and foreign tax rates.  That’s the reason multinationals are constantly lobbying Congress to declare a tax holiday for repatriations like these.

It will be interesting to see what happens.

 

Note:  the one virtue of what I consider the otherwise loony border tax is that it would remove the appeal of the extensive network of transfer pricing/IP transfer schemes already in place.  More about this tomorrow.

 

sovereign wealth funds and ETFs

Monday’s Financial Times notes that the Qatar Investment Authority (QIA), the sovereign wealth fund of the Middle Eastern State of Qatar, is changing its investment strategy.  Qatar is a country of 2.2 million people and 15 billion barrels of oil (that we know about), making it one of the wealthiest places on earth.

Since its inception in 2005, the $335 billion QIA has focused on expensive “trophy” assets, like the Canary Wharf property development and Harrods in the UK and film company Miramax plus 13% of Tiffany in the US.  It owns high-end hotels and office buildings all over the place.

According to the FT, however, the QIA has now decided to shift its focus to index funds and ETFs, indicating to the newspaper that the world supply of new trophies waiting to be bought is running low.

Maybe this is true, although there is a much more obvious issue with the QIA’s holdings that neither it nor the FT allude to.

Such trophies are virtually impossible to sell, except maybe to other Middle Eastern sovereign wealth funds.

Hotel companies in the US, and latterly elsewhere, have spent the past two or three decades shedding their properties–while retaining management contracts–because the returns on ownership are so low.  Iconic office buildings are a much better return bet.  But, again, there are only a limited number of possible buyers of, say, a $5 billion project.  A sharp price discount would likely be in order to compensate for taking on an expensive, highly illiquid asset like this on short notice–doubly so if the buyer sensed the seller was having cash flow problems.

It seems to me that the QIA bought into the narrative of “peak oil,” meaning a looming shortage of crude, that has been the consensus among oilmen for the past couple of decades–up until the emergence of mammoth amounts of shale oil production from the US three years or so ago. that is.  So liquidity was never a consideration.

I think the QIA change of strategy is the prudent thing to do.  It’s odd, though, that the QIA is calling public attention to the shift.  This would seem to imply at least that it has no need to divest any of the trophies it now has on its shelves.

Of course, something deeper may be going on as well, since the unasked question is who else may be in worse shape and may want to offload illiquid assets before its cash squeeze becomes evident.

Surprise!  That train has just left the station.

 

 

yesterday’s S&P 500 stock price action

Yesterday may have marked an inflection point in the US stock market.  Today’s potential follow through, if it happens, will give us a better idea.

Domestically, Mr. Trump appears to be moving on from pressing his social program to tax reform–and, maybe, infrastructure spending, both of which are issues of potentially great positive economic significance.  At the same time, results of the first round of the French presidential election (which pollsters got right, for once) seem to suggest the threat that France might leave the euro, thereby reducing the fabric of the EU to tatters, is diminishing.

yesterday’s S&P 500

How did Wall Street react to this news?  The sector breakout of yesterday’s returns, according to Google Finance, are as follows:

Staples          +1.7%

Finance          +1.6%

Industrials          +1.4%

IT          +1.4%

Materials          +1.2%

Healthcare          +1.1%

S&P 500          +1.1%

Energy          +0.8%

Consumer discretionary          +0.7%

Utilities          +0.6%

Telecom          +0.3%.

winners

Staples led the pack, presumably because this sector has the greatest exposure to Europe–and a rising euro.  Financials advanced significantly also, on the idea that stronger economic growth will lead to rising interest rates, a situation that benefits banks.

Industrials and Materials perked up as well.  Again, these are sectors that benefit from accelerating economic growth.

losers

Energy marches to the beat of its own drummer. The rest are consistent with the story behind the winning sectors, either defensives or beneficiaries of moderate (that is, not rip-roaring) economic performance.

My guess is that this pattern may continue for a while yet.  Personally, I’m most comfortable participating through Financials and IT.

 

 

 

 

the French election, round 1: market reaction

As I’m writing this just after 8am est, the French stock market is up by about 5%, large-cap European issues are up 4%, the euro is up by 1%+ against the US$, and stock index futures show US stocks opening up about 1%.

This is all because yesterday’s first round of the French presidential election ended up pretty much as the polls had predicted.  Candidates with 5%+ of the vote, in their order of finish, are:

Macron          23.9%

Le Pen          21.4%

Fillon          19.9%

Mélenchon          19.6%

Hamon          6.3%.

Fillon, an experienced politician and candidate of the center-left, had been the early favorite, but was undone by a scandal involving no-show government jobs for family members that paid, in total, more than €1 million.   Fillon’s subsequent refusal to withdraw directly undermined the prospects for Macron, the centrist candidate, and gave life as well to Mélenchon, of the far left.

The market fear had been that, with the center/left vote split three ways, Marine Le Pen, the far right choice, might end up doing surprisingly well.  That worry was intensified by the Brexit vote, the Trump victory and a terrorist incident in France last week.

The stakes in this election are very high.  Le Pen’s key economic platform: leave the euro and repudiate French euro-denominated debt.  The euro would be replaced by a new franc, which would be rapidly devalued–à la Abenomics in Japan–in order to give the economy a short-term boost.  Repaying euro-denominated French government debt with francs would “solve” the problem of French national debt, but at the cost of destroying the country’s ability to borrow internationally in the future (think: Argentina).  Were the Le Pen agenda to be implemented, it’s not clear to me how the EU could survive.

The consensus view now is that the Fillon and Mélenchon votes will gravitate to Macron, giving him a large victory in the second round of the election, between Macron and Le Pen, on May 7th (and earlier version of this post had the incorrect date).  Let’s hope so.

We now have whole week until the potential US government shutdown over funding for the Trump-envisioned border wall with Mexico.

 

 

 

 

 

 

failed shopping malls

There was a local politician on Long Island a while ago who had an unusual campaign position on gun control.  He argued that guns don’t kill people; bullets do.   Therefore, we should not control the purchase or possession of firearms;  we should control the purchase/possession of bullets, the real culprits.  He lost–or at least I hope he did.

The Wall Street Journal ran an article yesterday, apparently based on a recent Wells Fargo research report on failed shopping malls.  Its conclusion:  dead shopping malls are being killed, not by online shopping, but by the proliferation of newer, larger, more glitzy, better-located other malls.

There is certainly something more to this argument than to the bullet one.  Commercial real estate is a boom and bust business.  Developers put up new structures with relentless fervor until the day the banks shut down their access to credit.  And that usually doesn’t happen until the first bankruptcies of failed projects begin to appear.  As the old banking adage goes, “You never get promoted by turning down a loan.”

So, yes, older, smaller, less well-located malls are losing out to newer ones.  And the loss of anchor stores is usually the signal that the party is over.

But if we do a little arithmetic with the Census Bureau data on retail sales in the US, we can conclude that although online retail sales represent less than 10% of the total, they account for half the overall growth in retail.  Bricks-and-mortar retail is advancing, if that’s the right word, at about 2% a year.  It may be that if we adjust for inflation, the movement of physical goods through the traditional retail chain is flat.  So because of the internet there is no need for any net new mall space in the US.

From a retail firm’s perspective, BAM revenue growth is probably only going to come by taking sales away from competitors.  In a mature environment like this, cost control becomes an increasingly important source of profit growth.  Both factors imply firms should have better control over floor space and adjust it frequently to be in the most attractive locations.

Who knows what mall developers actually do, but if it were me any new project would need to explicitly target aging malls in its vicinity.   Those would be the primary source of the revenues that would make the project viable.

Two conclusions:

–if half the growth in retail weren’t being siphoned off by the internet, I’d guess the tectonic plates of malldom wouldn’t be shifting as violently as they are now, and

–the idea that ownership of physical store premises is a hidden source of value for mature retail firms (think:  the attack on JC Penney) has passed its use-by date.

 

 

tallying up the cost of Brexit

How good is the UK, the part of the EU most American investors know best, as a way to participate in potential economic strength in Europe over the coming 12 months?

Probably not good at all.  Here’s why:

–since the Brexit vote last June, sterling has depreciated by 13+% against the US dollar and 8+% against the euro.  While the loss of national wealth in Japan through depreciation dwarfs what has happened in the UK, the blow to holders of sterling-based assets is still immense.

Depreciation lowers the UK standard of living and reduces the purchasing power of residents by raising the cost of imported goods.  While one might argue that the fall in sterling is in the past–and while the consumer will be in trouble benefits to export-oriented firms through lower costs are still to come–this may not be the case here.  More in point #3.

–there’s some evidence that UK residents, realizing last June that prices would soon begin to rise, did a lot of extra consuming before/while firms were marking up their wares.  If so, the UK economy could be in for a significant slowdown over the coming months, both because consumers are now poorer and because they’ve already used up a chunk of their budgets through anticipatory buying.

–much of the appeal of the UK as a destination for export-oriented manufacturing comes from its position as the large foreigner-friendly country in the EU, from which multinationals could reach into the rest of the union.  That’s no longer the case.  An article from yesterday’s Financial Times is titled ” Brussels starts to freeze Britain out of EU contracts.”  Its basis is an EU government memo, which, as the FT reads it, advises staff to:

–avoid considering the UK for any new business dealings where contracts may extend beyond the two year deadline for Brexit

–cancel existing contracts with UK parties that extend beyond the Brexit deadline

–urge UK-based companies to relocate to continental Europe, presumably if they want favorable consideration for new business.

It seems to me that the EU leaked this memo to the FT to get the widest possible dissemination of its new not-so-friendly-to-the-UK policies.  It implies that the post-Brexit business slowdown in the UK will start immediately, not in two years.

One set of potential winners:  UK-based multinationals that do little or no business with the EU.  These, like ARM Holdings, are also potential takeover targets–although it’s questionable if the UK will permit further acquisitions by foreigners.