The Trouble With Taxes

Taxes are tricky things. Most folks agree they’re necessary, but most also don’t much enjoy paying them—or at least, they’d like to pay as little as they can. (I don’t really blame them—I also prefer spending my money as I choose, not the way the government chooses.) And that includes some politicians and celebrities, several of whom seem allergic to paying them altogether.

Taxes also raise numerous philosophical questions about “fairness.” Some argue taxes can mitigate “wealth inequality” (in my view, a solution in search of a problem, and an idea we discussed more fully recently on Real Clear Markets). But here, let’s look at taxes from a strictly economic and market perspective—an important factor for investors as election season approaches and the age-old parade of candidate plans commences.

From a consumption perspective, higher taxes likely have some negative impact on consumers’ desires to purchase those goods—particularly when there are acceptable substitutes. For example, if massive tax rates were suddenly applied to ice cream purchases, folks might start buying sherbet or frozen yogurt for their sugar fix instead. Or make their own ice cream! (And there are myriad real-life examples of such taxes causing substitution—like the early twentieth century battle between margarine and butter, for one.)

But for some things, there aren’t great substitutes, like gasoline, and/or they’re “inelastic” goods folks think are essential. And here’s where you can sometimes get an odd dichotomy. Inelastic goods are sometimes targeted for higher consumption taxes as sure-fire revenue boosters. At the same time, when politicians want to influence behavior (getting folks to drive less, smoke less, drink fewer sugary drinks), they may also boost (or attempt to boost) taxes to deter consumption. So, politicians understand increasing the price of something they disapprove of likely makes folks do that less but don’t believe raising taxes on other items also similarly influences behavior?

Which brings us to production taxes (i.e., on individual or corporate income). It’s pretty likely in the face of onerous taxes or an incredibly complex tax code, individuals and corporations do what they can to minimize tax bills. For corporations, that could mean expanding overseas operations or paying for accounting and legal resources. For individuals, it could mean, again, paying for an accountant, gifting a portion of their income, sheltering it in tax-exempt or -deferred vehicles or even possibly curtailing earnings. That individuals and corporations take such steps is not the stuff of myths, either—consider recent stories of corporations that paid nearly nothing in US taxes. Or wealthy business leaders who claim to pay less in taxes than their subordinate employees (to the consternation of many, at that).

This seemingly leads to something of a vicious cycle, whereby as individuals and corporations figure out how to mitigate their tax bill—thereby effectively shrinking the tax base—politicians decide the only recourse is raising tax rates or taxing more goods. Which then incentivizes more folks to find alternatives to minimize their tax bills. On and on until we’ve reached the point the tax code is 72,536 pages and it takes an estimated 6+ billion hours and billions of dollars annually to comply.

So it seems the argument the tax code is overly complex and onerous in many respects is hard to refute. But it leaves the question of what to replace it with. Republican presidential candidate Herman Cain has introduced what’s by now a well-known and much-discussed alternative, known as the 9-9-9 Plan, which would basically scrap the current national tax code and replace it with three 9% flat rates: one on corporate income, one on personal income and one on sales. And Texas governor Rick Perry recently introduced his own Cut, Balance and Grow Plan.

Needless to say, both plans have sparked controversy on both sides of the aisle. I’ll leave readers to do their own research and assess the various arguments. But one thing’s certain: They’re both far simpler than the existing tax code, which to my way of thinking is a step in the right direction. They’re also much more transparent. Without all the loopholes and exemptions, folks would know what to expect their tax bill to be yearly (assuming Congress left it largely alone, which I realize is a tall order). So would businesses—which makes planning simpler and likely encourages funds currently parked overseas avoiding onerous repatriation taxes to come home.

And that’s the main point: Simpler would be better. Flatter (like Cain’s or Perry’s plans) would also likely encourage much less evasion (legal or otherwise), which could very well increase overall revenues (a point Art Laffer made in the 1980s).

But what matters most for investors is market impact. And here, the results are likely fairly mixed, too. First, consider the fact a major change in the tax code would hardly sneak through Congress—look no further than the current level of media hoopla over the various plans (not even legislation yet—nor likely to be anytime soon) for proof markets would have sufficient warning and consequently largely price in any tax code changes. Second, US tax policy is just a piece of a cog in the global economy—the majority of economic activity and global market cap is outside our borders and thus, isn’t subject to whatever decisions the loonies in the Beltway make.

Some changes, like eliminating or lowering the capital gains tax, could even conceivably have a short-term negative impact on stock prices since a number of investors would likely rush to realize tax-free gains, which in the very short run could depress stock prices some. (Though, history on the stock market impact of capital gains tax rate changes is very mixed.) But aside from that, a simpler tax code would probably encourage businesses to rededicate resources to more productive uses than tax planning. And a lower tax rate would no doubt encourage expansion, hiring, etc.

But consider the fact that since the government began deducting taxes from paychecks in the mid-1940s, tax rates have been all over the map, but tax receipts have consistently averaged roughly 18% of GDP—sometimes a bit more, sometimes less, but generally right around there. And most changes in that percentage lag economic cycles some—meaning they’re not much tied to tax-rate changes. So overall, tax-rate changes don’t hugely impact overall federal tax revenue—positively or negatively.

Similarly, history shows markets are little impacted one way or the other by tax-rate changes in the near or long term. Meaning it would likely be a mistake to become overly bullish because of tax cuts (see 2001) or overly bearish because of tax hikes (see 1993). Sure, they’re a variable in a larger equation, so they can have some impact—but it’s likely fairly small, and one more global factors can swamp. Widely known political footballs like the tax code likely lose most of their market impact because they’re just that—widely known. At the end of the day, politicians dithering and debating taxes from endless angles is nothing new—nor is the fact markets typically yawn when politicians yap.