Arohan’s investing life

Senator Barack Obama outlined his economic policy highlights today, were he to become the next President of United States. His position on Capital Gains taxes is quite alarming and can have a profound effect on the US economy if it becomes a reality

Senator Obama is willing to increase the Capital Gains tax rate to 25% range (but definitely not more than 28% according to him). Ostensibly the higher tax revenue will go towards funding more government social programs

Double Taxation: All will agree that taxing dividends is a form of double taxation. Dividends are paid out of the after tax earnings of a business. It is however worth noting that taxing capital gains is also, maybe a bit subtly, a form of double taxation. Stock price of a company over a long term is directly linked to the growth of the business’s equity. Positive Net Income increases the the equity of a business. When the business pays taxes on its net income, the equity of the enterprise is decreased, thereby decreasing the value of the stock that an investor holds in the company (meaning the capital gains to the investor are reduced because the company pays income taxes on its income). This is the first instance of taxation (although indirect) on the investors assets. The second instance of taxation of course occurs when the investor sells stock and realizes a capital gains

In my mind, double taxation is simply wrong and just serves to discourage investment activity which is crucial for any capitalist economy to work. Much as I fault the current administration in many of the things they have done (or not done), they were on the correct path of reducing (and hopefully ultimately eliminating) the capital gains tax

Now back to Mr Obama’s proposal to raise the capital gains tax. I can think of many implications it has for the business environment in this country.

For investors:

• Low capital gains tax rate was an indirect way of encouraging the citizenry to migrate to an ‘Ownership model’ and invest in public assets. With Mr Obama’s proposal, owning stocks will become less attractive
• Countless studies have shown that over long term, stocks as an asset class outperform all other publicly investable asset classes. This is specially true if you compare the long term tax-adjusted returns of various asset classes. With increased capital gains tax rates, this gap will shrink. While this may not be a immediate game changer for young investors who have a long time frame, it is certain to change age based asset allocation models with people moving to more conservative assets earlier than they currently do (as the risk/reward ratio becomes worse and risk appetite lessens). This of course is a problem magnified when you consider that the older investors typically have more money invested in the markets. This may have an unintended result of depressing stock prices over a long term and therefore make owning stocks even less attractive
• Venture funding and Private Equity are essential to the business eco-system in this country. It drives innovation, new business models, new products, provides liquidity to the markets so inefficiency in the system is continuously removed by various restructuring and other market machinations. Firms in this industry take a long view and extraordinary risks for that capital gain when they execute their exit strategy. Raising taxes on this industry will put a damper on the startup and SMB activities thereby taking the shine off the core growth engine of the economy. Mr Obama will indeed need more money to fund social programs as the job creation in this country will slow down and those social programs will be in great demand.
• Growth companies will be pressured to return capital earlier in form of dividends or other distributions as investors become indifferent to dividends versus capital gains AND as the companies themselves see some lessening in attractiveness of reinvesting in other growth projects

For Businesses:

• As investors demand higher returns to compensate for the increased government’s take, businesses will likely increase their exposure to the debt markets, leveraging up their balance sheets. More interest payments and possibly more dividend payments imply a reduction in the balance sheet quality and a reduction in the risk appetite for the businesses
• more stakes in American companies will be sold to overseas investors who may not be burdened with such high capital gains taxes in their countries

For the general public:

• Less employment, less asset ownership, more social programs, bad deal all around

This may sound alarmist, but the fact is that all this will come to pass. It will not happen overnight, more like a slowly boiling frog. Of course, when this starts being a problem, Mr Obama will have ended his term and it will be someone else’s mess to fix …

All this will come to pass as a large portion of our workforce (babyboomers) will leave the workforce and retire.

Senator Obama is a likable candidate and will bring Statesmanship and Oratory back to the office and may even be a hit on the international circuit but with policies like this he will surely destroy the economic standing of USA in the globe. Oh, and more regulations that he espouses will not help

Better increase your allocation to international assets if it becomes likely that he may be the next President of USA

Related posts:

1. Why Warren Buffett is richer than the Hedge Fund managers - a tale of two business models
2. Global markets decline - is there a value in international diversification?
3. Recession is here! What should an investor do?
4. Investing in 401K plans - when is it not worth the trouble
5. On Banks and writedowns