"Kee" Points with Jim Kee, PhD.

US stocks are up about 3.2% (S&P 500) since the November 8th elections, with small company stocks up over 8%. This would fit expectations for higher future US growth, as smaller companies are more levered to local economies than large, multinational companies, which are more levered to the global economy. Small companies also pay higher effective (actual) tax rates than large companies, which makes them a bigger beneficiary of Trump’s proposed lower corporate tax rates. Corporate tax rate cuts increase the value of the future cash flows that companies are expected to generate (higher earnings), while lower investor taxes on capital gains and dividends increase the amount investors are willing to pay for those cash flows (multiple expansion). This latter effect is called a multiple expansion because investors value future earnings (profits) as well as present, so they pay a multiple of what present earnings are worth. If the expected future earnings of a company rise, then investors pay a higher multiple of present earnings, hence the term multiple expansion. As for these investor taxes (dividends and capital gains), so far Trump’s plan only explicitly discusses eliminating the 3.8% net investment income tax on capital gains that was part of the Affordable Care Act, but perhaps the market is repricing expectations of a Clinton win, as Clinton’s proposed tax plans included explicitly higher capital gains taxes on certain income earners.

If you were to really look at valuations and estimate what are known as “equity risk premiums,” Europe would look the cheapest (Credit Suisse Holt). That makes sense, and not just because of Europe’s ongoing debt and refugee problems, but also because more referendums are calling into question the whole European Union or Currency Union project(s). At the onset of the European debt crisis six years ago I cited economist (and Nobel Laureate) Robert Mundell who pointed out that Europe’s debt problems (borrowing money that can’t be repaid) had nothing to do with the euro. I also cited another Nobel Laureate, Thomas Sargent, who argued that Europe was where the US was early in its founding, where it was hammering out federal fiscal (tax/spend) authority versus individual state authority. I still think that is a valid way to view Europe, but with the lack of progress in the ensuing six years I think the probability of Europe staying intact has fallen a bit. I think that is somewhat reflected in the euro itself, which has lost about a quarter of its value over the last two and a half years. When inflation rates are fairly consistent across countries, exchange rate movements are less driven by monetary factors and more driven by real factors, like growth and risk. US growth has been mediocre, but the best of the developed world; and risks have risen in Europe. We should expect to see a stronger dollar/weaker euro, and we have. Central bank policies (looser in Europe, tighter in the US) have certainly worked in the same direction.

Last week I mentioned that I would discuss tax policy from a microeconomic perspective. Basically, Trump’s plan calls for corporate, payroll, and (limited) capital gains tax rate reductions (and estate tax/AMT elimination) as well as infrastructure spending and renegotiated trade deals. In a nutshell, I go back to the insight that wealth is created by production and exchange. I think the corporate and income tax rate reductions/simplifications will facilitate production and lead to stronger growth, while the infrastructure spending will be a wash but won’t hurt. I think the trade discussions have the most potential to be wealth destroying by reducing exchange, if in fact a trade war does ensue (not my expectation). That’s it for this week’s Kee Points! If interested, I have included a more analytical discussion (addendum) below. The last time I did deep dive on taxes was six years ago (December 2010), so some Kee Points readers might find the following discussion vaguely familiar.

Addendum: Some Tax Analytics

Income (aggregate demand) versus excise (relative price) effects: About 30-40 years ago there was a debate among academics and policy makers regarding the economic effects of tax cuts. On one side were those who advocated tax cuts because they increased spending (aggregate demand) by leaving people “more money in their pockets” to spend. This group, call them Keynesians, was big on things like tax rebates and tax credits. The other group, called ‘supply-siders’ by the late journalist Jude Wanniski, argued instead that spending in the aggregate remained roughly the same, at least initially; More private spending because of lower taxes would be offset by less government spending because of lower tax revenues. If government continued to spend by borrowing, then private sector purchases of government bonds would mean lower expenditures on goods and services. This group argued that tax cuts lead to increased output and employment not by leaving people with more money to spend but rather by increasing the relative prices or attractiveness of economic activities (work versus leisure, savings and investment over consumption, and high risk/reward activities versus low risk/reward activities). They argued that increases in spending or ‘aggregate demand’ were a secondary effect, the result of increased efforts to work, save and invest. Tax rebates and credits to them were just basically taking money out of one pocket and putting it into another. In fact all spending or “aggregate demand schemes” basically fell into this category of taking money out of one pocket and putting it into another (redistributing the pie rather than growing it). This would include things like infrastructure spending or even lower interest/mortgage rates, i.e. people paying less for a mortgage do have more money to spend on other things, but people receiving mortgage payments (lenders) have less money to spend on other things (international linkages complicate the analysis somewhat). By the way, this “supply-side” view is based upon the work of economist Norman Ture, who influenced both the Kennedy and the Reagan tax cuts. Few politicians make this distinction (between income and excise effects) today. Even George W. Bush, who called himself a supply-sider, argued that tax cuts would stimulate the economy by leaving people more “money in their pockets to spend,” not by changing the relative prices of productive activity, so he didn’t get it either.

My view: The real wisdom comes from seeing that both views can be correct depending upon the circumstances. When there is a lot of slack (unused labor and excess equipment capacity) in the economy there is a case for Keynesian demand-side stimulus, which is particularly true in times of crisis like 2008. That’s because money earned by firms and individuals does not get channeled into investment spending through financial intermediaries but rather builds up as cash on the sidelines, e.g. money market mutual funds and corporate and bank balance sheets. People earn income and hoard rather than spend, so spending is less than income and all of the nation’s output is not purchased (sold). That means idle capacity. But longer-term I think the evidence in the U.S. and world history supports the notion that countries with less punitive tax systems tend to prosper relative to those with more punitive tax systems. So expect income effects to dominate in times of crisis, and relative price (excise) effects to dominate under more normal circumstances (this view influenced by the work of UCLA economist Axel Leijonhufvud).

Corporate and payroll taxes: I’m sure most of you are familiar with the economists’ view that corporations don’t pay taxes. Rather, they are either (a) passed along to customers in the way of higher prices, (b) passed backwards in the way of lower payments to suppliers or workers and workers’ benefits, or (c) paid by shareholders in the way of lower after-tax income, which gets “capitalized” in a lower stock price (because the value of a company equal to the discounted present value of future after-tax earnings streams). Of course, it is probably some combination of “all of the above,” but the point is that the statutory incidence of a tax (who the government says must pay it) is different from the economic incidence of the tax, or who really bears the burden (which is determined by the market). That’s also true of the dichotomy between the “employer’s” portion of payroll taxes and the “employee’s” portion. In occupations where demand is high and supply of qualified personnel is limited, employers will bear most of the burden of the tax (offering higher pre-tax salaries or wages). In occupations where demand is low and workers are abundant, workers will bear most of the burden of a payroll tax in lower pre-tax wages. Either way, labor supply curves are thought to be more ‘inelastic’ (less responsive) than capital supply curves, so the economic impact of payroll tax cuts is smaller than tax cuts on capital (profits, dividends, capital gains).

Estate taxes: Most discussions regarding estate taxes are normative, i.e. “should the government have the right to tax my estate?” But the economic analysis of estate taxes has to do with their impact on savings and capital formation. For example, income is taxed when it is earned. If you then spend what is left on a vacation, then there is no further federal tax. If the income is saved, however, then the returns to those savings are taxed as dividends, interest income, or capital gains. If that savings is in corporate stock, then the corporate tax hits the income before it is paid out to shareholders. If what remains is then left to another as part of an estate, then it is again taxed under estate taxesThat’s what economists mean when they say that the current tax code punishes savings relative to consumption. The idea is that lowering or removing these layers of taxes on savings will lead to more savings, capital formation, jobs and growth. I have no doubt that this is true, but I don’t have any real conviction in the models that I have seen which try to quantify the impact of estate taxes (or lack thereof) on the economy (like a lot of things it is very hard to isolate).

Impact on the stock market: Try to think about dividends and capital gains taxes as investor taxes. The value of the stock market is equal to the present value of the discounted earnings or cash flows of the companies that comprise it. The size of those cash flows is driven or “set” by management decisions and the overall economy. Corporate income taxes affect these cash flows directly. The discount rate used to value those cash flows is set by investors. Investors require a real, after-tax rate of return. They have to be compensated for risk and inflation, and that determines the discount rate or required rate of return. Taxes are on top of that, so taxes raise the discount rate, which lowers the present value of the discounted cash flows, which lowers the value of the stock market. Cutting these investor taxes lowers the discount rate or required rate of return and increases the value of the stock market. There is a grey area or “no man’s land” in trying to quantify what the market is already expecting and priced in, but I think it is safe to say that the market was not expecting a Trump win and so was not pricing in any tax rate reductions.