Thursday, October 19, 2017

Tax Cuts and the Stock Markets

The tax system is definitely biased towards the rich. Vox came up with an "explainer" video on how Tax cuts benefit the rich asymmetrically.

I wish to clarify "rich" people as defined here are people who rely solely on investment income. This income is taxed at a much lower rate than earned income. This is already a huge boost to people who seek to play the market as a means to get wealthy. With the proliferation of investment tools, it has become too easy for ordinary people who are otherwise risk averse to be lured into poorly secured investments in the stock market.

The video is pretty instructive in that it tells you that a 5% tax cut results in a lot more actual $ being transferred to a rich person's wallet than your own but it doesn't tell you how this affects the stock markets.

There are two mechanisms by which it can affect the stock market.

1) In anticipation of a large tax cut, rich people will boost speculative pricing bubbles. These bubbles have the benefit of making their income seeing larger. That in turn will allow them to claim a larger dollar amount as a cut.

2) If a tax cut does not materialize then the rich are forced to deflate the stock market. Unless they do this, they will not be able to reduce the amount of money they owe as taxes. They make money by deflating the stock market because they pay less tax.

Here is a simple example.

If I am super rich and I have $1B in a portfolio I invested in at the beginning of the year and the market grows at 20% throughout the year. Then when I sell my portfolio at the end of the year, I have made $200M as investment income. This should get taxed at say 23.8%. I would end up owing Uncle Sam about $47M. If Trump gives me a 10% tax cut, then my earning would be taxed at the 13.8% rate so I would owe only about $27M. I would have "made" an extra $20M thanks to Donald Trump.

Now Donald Trump fails to deliver on the tax rate cut, I would still want to "make" $20M, I would do whatever it takes to drop the value of my income to $113M. Taxed at the original rate, I would end up paying $27M. Since my income is directly tied to growth rate of the market, I would have to see my portfolio grow at 50% the rate of the market's current 20%  AGR.

Since my investment income is calculated on an annual basis. To move its net growth rate down by 50% after half of the year is over, I would need to freeze the portfolio value at its current level. If I had to drop the annual growth rate to 50% after 2/3 of the year was over, I would have to drop the value by 10%. As we get closer and closer to the end of the year, my portfolio has to shrink massively in order for me to keep the amount of tax I pay the same (see graph below).

In order to get there, I would need to start selling my own stock at a much lower price than it is currently valued or at volumes that would cause the price to drop. This should be okay as I had deliberately stoked speculation that had over-valued it in anticipation of a tax cut.

This is why Secy Mnuchin says that if the tax cuts are not passed the market will collapse. [1]

Unfortunately for my toy model, in reality I am not the only player in the stock market. There are others who may seek a very different reduction in the value of their own portfolio, so if I start something, there is no guarantee it will stop when I want it to. This creates a lot of room for political pressures and factional dynamics. You may recall the role of the bankers' pool led by J P Morgan in 1929. They wanted the crash to stop but it didn't and that landed them in a hole they didn't want to be in.

This is obviously overly simplified, but it should give you a snapshot of what is likely in the near future.


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