Iron Capital Insights

  • Iron Capital Insights
  • October 4, 2017
  • Chuck Osborne

A Taxing Debate

It is hard to think of work when tragedy strikes like the one in Las Vegas Sunday evening. Our thoughts and prayers are with all those who have lost loved ones and suffered injuries in this truly senseless act.

Even in tragedy, life goes on and the market keeps on going. The fact that the market has been positive thus far this week suggests to me what we already know: The computers are in charge of the short-term movement today. Investors have always been characterized as being heartless, but the machines actually are.

The machines and the humans who program them are focused on tax reform. Will it get done? It brings to mind the last time tax policy was really under debate. We dedicated an issue of our Quarterly Report newsletter to the subject in 2010, which can be re-read here. Back then we were talking about raising taxes and now the talk is about lowering them, but the principles of tax policy remain the same.

The biggest area of concern for the markets is corporate taxes. The United States has the highest corporate tax rates in the developed world. Our outdated system puts us at a disadvantage for global competition. Of course, politics will be played, but this was an agenda item for the last administration as well. We need to reform our system.

Those against reform will tell you this:  While 35 percent is the stated rate in the U.S., what actually gets paid is a more modest 24 percent. That number comes from the Center on Budget and Policy Priorities. The response to this argument should be to simply say, “Exactly.” You see, this is the problem in our system and it is the problem with high tax regimes in general. Politicians love to get on the stump and rant about those evil greedy capitalists. “They are going to pay their share. We’ll have the highest rates in the world.” Then they quietly say, “But we didn’t mean you, Mr. Donor. Your company will be given a loophole.”

It is very popular today to claim that the American system has become rigged, but no one then reflects on how would one actually go about rigging a system? One way would be to make tax rates very high and then give out loopholes to favored taxpayers. This may sound like blasphemy, but we might not need a tax cut right now; we are, however, badly in need of tax reform.

The biggest beneficiaries of real reform would be smaller companies. These are the ones who end up actually paying the higher rates. Of course, because of the high rates and the fact that business income is actually taxed twice if it is paid out to owners, many small businesses have gone to alternative business structures where the business income is “passed through.” This means the owners simply include the business income in their own personal taxes. This works for several types of companies, but the problem for many is that this system provides a disincentive to reinvest in the business.

If a business owner is going to have to include all the business income in his personal taxes, then why would he not at least get the personal enjoyment of that money? To grow one’s business an owner must reinvest in plants, equipment, training of workers, and ultimately more workers. If she has to pay personal income taxes even if she didn’t spend the money on herself, then why would she reinvest? The data over the last decade-plus would indicate that the answer to that question is that she wouldn’t.

Our economy cannot grow if businesses do not grow, and businesses cannot grow without investment.  We need a system that encourages investment, and one that does not favor one industry or company over another. Will we get it? Doubtful, but unlike politicians who allow perfection to be the enemy of progress, the market will applaud progress. If we get anything that reasonably could be called reform, it will help the economy and that, in turn, will help your portfolio.

Warm Regards,

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Chuck Osborne, CFA
Managing Director