The US corporate tax rate

We have long argued that lower tax rates are crucially important for economic growth, and that lower rates can actually result in increased tax revenues. Moreover, because those who control most of the capital that is used for production (rather than consumption) will respond very quickly to changes in tax rates, cranking up tax rates on the profits that result from productive activity is even more counterproductive and damaging to growth.

If this is true for individual tax rates, it is just as true for corporate tax rates. In fact, it is especially true for corporate tax rates because earnings that corporations retain are typically invested back into productive activities that employ more individuals or result in purchases of plant equipment, IT equipment, and so on.

On this front, the United States has the second-highest corporate tax rate in the industrialized world, at 35% second only to Japan (see map showing world corporate tax rates, above).

Many politicians in the United States like to bash American corporations that do not bring home cash from their overseas operations, but when that cash will be more severely taxed in the US than abroad, can anyone really blame them?

If every road in your town was a toll road, but some toll roads charged $10 per day and others charged $35 per day, with all kinds of dollar figures in between, would you rearrange your daily driving based on the different prices, or just buffalo right through without paying any attention to the costs?

Capital behaves the same way -- it flows like a river, and it will flow around places that are unfriendly to it and towards places that are friendlier. The US corporate tax rate of 35% is equal to the 35% charged in Argentina and Angola. Canada charges 16.5% and Mexico 28%. Much of Europe is at or below 30% (except France), with Bulgaria at 10%, Ireland at 12.5%, and Latvia at 15%. To argue that corporations ignore such corporate tax rate discrepancies is really naive.

In order to stimulate economic growth, raise employment, and ultimately raise more tax revenues, the United States should lower its corporate tax rate.

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Christina Romer and the strong versus weak dollar debate

Here's a recent piece in the New York Times from Christina Romer, former Chair of the Council of Economic Advisors to the Obama administration and since 1988 an economics professor at the University of California at Berkeley (faculty profile here).

Entitled "Needed: Plain Talk About the Dollar," the essay decries the longstanding talking points that declare that "The exchange rate is the purview of the Treasury" and "The United States is in favor of a strong dollar."

Romer counters both these assertions, explaining that the dollar responds to a lot more factors than simply the actions of the US Treasury (she outlines them clearly and articulately) and chastising those she calls "strong-dollar ideologues" who reflexively prefer a strong dollar, without realizing what she sees as the occasional benefits of weak-dollar policies.

She says:
A weaker dollar means that our goods are cheaper relative to foreign goods. That stimulates our exports and reduces our imports. Higher net exports raise domestic production and employment. Foreign goods are more expensive, but more Americans are working. Given the desperate need for jobs, on net we are almost surely better off with a weaker dollar for a while.
We would respond to this argument by asking why we want the government to be engineering swings in the dollar's value in the first place! It strikes us that Professor Romer's argument assumes the premise that a small cadre of elite government officials are best able to decide when a strong dollar and when a weak dollar will create a situation in which "on net we are almost surely better off." Even if they could accurately make this determination (which is dubious), we are not sure that would argue that they should then act on it.

We would much prefer that the government get out of the business of engineering a stronger then weaker then stronger dollar and simply concentrate on creating a stable dollar. While proponents of government steering of the dollar might counter that such an idea is naive, we would argue that the government has no business steering the economy, and that their efforts to do so consistently result in disaster. For extensive evidence from recent history, see here, here, and here.

As for the idea that a weak dollar is good for Americans because it "stimulates our exports and reduces our imports," it strikes us that Americans who make their living importing goods (which other Americans want) might not be so quick to agree that taking away their livelihood in order to protect the livelihood of someone else is justified on the basis of the platitude that "on net we are better off."

This kind of privileging of one group at the expense of another was highlighted in our post entitled "The ugly tomatoes of protectionism," in which we saw how the family business of John Nix and his sons, who lived in New York and imported tomatoes from the Caribbean, was penalized by a law designed to protect domestic tomato growers from foreign competition. Where does the government get off in deciding that the interests of the tomato growers are more worthy than the interests of other citizens such as the Nix family? What formulas do economists use to decide that "on net" the oppression of the Nixes is more than compensated by the reduced competition experienced by the Smiths or the Joneses?

We completely disagree with those who argue that deliberately weakening the dollar is a good idea, and for reasons that go beyond the rather considerable problem we just discussed. In addition, artificially weakening a currency creates capital misallocations just like the ones discussed in the Fed oversteering posts linked above, feeding speculation and asset bubbles while starving worthy businesses of capital that would normally flow to them.

By the same token, we do not argue that the dollar should be artificially strengthened either -- the government simply does not have a good track record whenever they tilt the playing field to cause capital to flow one way or another. We believe that those decisions should be made by private parties, not by government officials. In order to allow private parties to make those decisions most effectively, the government should try to create a stable dollar and disavow any illusion that its public officials know better which way capital should flow.

This is not a position we are taking simply in response to Professor Romer's piece: we made this same argument almost two years ago in a post entitled "The 97-pound weakling," about the problems being caused by the weak dollar back then.
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People of Europe, Rise Up!

The markets are down sharply today over a downgrade to the outlook for Italy's credit rating, as well as over the rout of the socialists in elections in Spain over the weekend.

Investors might wonder, Why would socialists getting voted out worry the bond market? Spanish voters apparently revolted against "austerity measures" that the socialist government was implementing, but investors might scratch their heads because it doesn't seem that voting in a center-right government would spell less austerity than a socialist government.

Let's try to untangle some of the strings between austerity plans, protests, and the market reaction.

Europe is increasingly being forced to deal with the issue that we have called "The Question of our Time," namely the realization that seemingly endless government benefits have to be paid for by someone, and that in many countries (and a few US states) these benefits have become so generous that they will break the budget completely unless they are reduced.

The erstwhile socialist administration in Spain initially passed laws giving out even greater levels of benefits than before: everyone could get a government-paid scholarship to college, universal health coverage was extended to everyone for procedures including sex-change operations, childcare was paid for by the government, young adults received government rent money so that they could afford to be "emancipated" from their parents even without a job, and the minimum wage was raised even higher.

However, the bond market has a habit of imposing a reality check on countries whose spending threatens their ability to pay the interest on their debts, and in order to prevent credit rating cuts and higher borrowing rates, Spain's government executed a dramatic about-face and instituted an "austerity plan" to preserve its ability to borrow.

In Europe, the phrase "austerity plan" signifies reducing government spending and raising taxes. In Spain, for example, the government spending reductions included lowering pay for government workers by five percent and pushing back the age for retirement benefits from 65 to 67, while the country simultaneously increased the tax rate on the highest bracket from 43% to 45% and created a new bracket below the highest bracket that would pay 44%. The government also increased the tax on cigarettes by 24% in 2011.

We believe that European-style "austerity plans" are terribly damaging, not because they reduce government spending (which we applaud) but because they raise taxes, which further cripples the economy by reducing the ability and incentive for business creation, innovation and growth. As we've written before, growth is really the best answer in the long run.

Cranking up tax rates simply crushes growth. We have also written about the fact that the tax rate on the highest brackets matters an awful lot to everyone in the economy, even though many people don't understand why (see here and here for an explanation).

The bulk of the protests against austerity plans in Europe, however, does not seem to come from a recognition that taxing the highest brackets even more excessively will crush growth, but rather from anger at the reduction of the lavish benefits that are apparently viewed as a right.

In Spain, the Puerta del Sol in Madrid is now filled with thousands of young adults who are indignant at the high rate of unemployment, and the new austerity measures that they see as passing on the pain to the people in order to spare the pain to "the bankers."

This NPR story on the indignados (as the young protesters are called) notes that the young people are angry at the austerity measures and notes that one young man who lost his job two years ago and has a heavy mortgage "blames the banks" (presumably for giving him the mortgage, not for the loss of his marketing job). He declares, "The bankers from Lehman Brothers, Barclays Bank, Spanish bankers — all must be in jail." The story describes middle-aged women and restaurant owners who sympathize with the protesters bringing them food -- "vegetables and fruit, because many people are vegetarian."

This story from South Africa's Sunday Independent notes that demonstrators are particularly angry with the austerity measures because they came from the socialist party that is supposed to support government spending. "It is a socialist government but they are implementing the same policies as Sarkozy in France, Merkel in Germany and Cameron in Britain," one spokesman complained. "This directly affects the welfare state." The idea!

But why would the voting out of the socialists worry the international markets? We believe it has to do with the mistaken Keynesian ideas that still dominate the thinking of many economists, even on Wall Street and in big international financial institutions. Many do not accept the argument that lower taxes and less government spending is good for growth. While the center-right governments of Europe are not exactly libertarian when it comes to taxes and the role of government, it is probable that many observers believe they will be less likely to raise taxes than the socialists would be.

The perception that government spending grows the economy and that cutting government spending means less stimulus and less growth is wrong, in our view, and yet it still operates as an underlying assumption for many modern intellectual descendants of John Maynard Keynes. There is plenty of hard evidence that government spending not only does nothing positive for economic growth, but in fact has a negative impact -- see this previous post which discusses evidence from history.

Keynesians in general believe that consumption drives the economy (which is why they think government spending helps the economy by stimulating more consumption). However, production is what really drives an economy and what Spain and other European countries such as Greece and Portugal need to stimulate.

It may seem like it's too late for some of these European nations to figure out how to become productive members of the economy again, but to this negative assessment we would reply: "It's never too late." There are plenty of examples of countries with moribund economies getting rid of bad economic policy and experiencing dramatic turnarounds. Israel and New Zealand are two that come to mind.

We would argue that human beings everywhere possess the potential for incredible and unexpected innovation and creativity. To unleash it, governments need to remove the shackles of high tax rates, and stop paying people not to work.

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Bulls always win

With the ongoing high unemployment and signs of building inflationary pressures, the bears are starting to come out with predictions of economic catastrophe.

There is a school of thought which argues that the entire recovery from the recession of 2008-2009 was a fabrication of the easy Fed policy and subsequent injection of additional easing through QE2, and that now that those drugs have run their course, the hangover is going to be horrendous.

Such a view is on display in a recent Barron's article by Randall Forsyth, "Anticipating the Removal of the Punchbowl," in which the author cites a quotation from Cantor Fitzgerald's chief economist who asks, "So, what happens when they take the addict off the dope?" The "dope" in this case is quantitative easing, or as the article puts it: "the Federal Reserve's $600 billion Treasury securities purchase scheme to pump liquidity into the financial system." He implies throughout the article that the rise in prices of stocks and other "risk assets" are the product of continual "spiking the punch bowl" by the Fed, and cites frequent bear Jeremy Grantham who advises, "Sell in May and go away for 41 months." Forsyth notes that while Grantham "freely admits to being early many times with his calls since the early 1970s, he notes they have eventually worked out."

Another bear recently pointing out how his pessimistic market predictions have worked out is Doug Kass, who recently wrote an article entitled "False Sense of Security," taking the bulls to task for their optimism in 2008 and saying they are making the same mistake again. He declares that the problems of today are worse than the predecessors, and says that "At best subpar growth looms on the domestic economy's horizon; at worst, a double-dip is still possible."

While bears such as Grantham and Kass can point to previous recessions as evidence that they were right, we would argue that in the long run, the bears are always wrong. Anyone who looks back over the past hundred years would have to admit that being a long-term bear would have been a huge loss.

Therefore, the bears are of necessity short-term focused: they try to predict a short-term downturn in order to avoid it, and then correctly predict the moment to get back in. We would argue that this is a fool's errand, and that saying "I've been early a lot but I'm always rewarded by a recession in the end" is a recipe for missing the real opportunity to participate in the growth that takes place while you are waiting for a disaster.

Contrary to the straw man argument that many pessimists will use in response to such criticism of their view, our long-term optimism does not mean being a blind pollyanna and investing in just any company (or even all companies via an index fund) forever. We believe in researching investments very carefully and looking for well-run companies positioned in front of exceptional fields of growth. Even in periods of "sub-par economic growth" for the economy as a whole, there will be innovative companies that are creating or profiting from major paradigm changes, and we believe in owning these companies through economic cycles and selling them when business conditions change, not when the unpredictable stock market conditions change.

We have pointed out that Thomas Rowe Price, from whom our investment process is descended, did not believe in trying to time cycles, and his long-term record speaks for itself. We would also point out that our process has led to significant outperformance versus the broader market over the past four years, even through one of the most punishing bear markets in American history.

In short, we are bullish on capitalism over the long term, and believe that as long as free enterprise is still allowed, bearishness is short-sighted. This does not mean that investors should not change their strategy based on the prevailing regulatory, monetary, and fiscal environment that they see developing -- that would be foolish, and we have written about the indicators investors should look for and changes they should make in a series of articles, such as this one, this one and this one.

We would caution investors to fight the urge to run under a rock every time the bears begin predicting disaster. This is not a game in which the bulls win some and the bears win some. Over the long run, the bulls always win.

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The ugly tomatoes of protectionism

Today's Writer's Almanac with Garrison Keillor calls attention to a US Supreme Court decision rendered this day, May 10, 1893 in which tomatoes were upheld as a vegetable.

What exactly this topic has to do with writers is a bit of a mystery, although the narration treated it as a quaint issue of semantics over whether something with seeds should be considered a fruit or a vegetable. In fact, however, the case illustrates the ugly power of tariffs and an all-too-familiar example of the heavy-handed government interference with free trade, privileging one business over another to the detriment of consumers in general.

In the 1893 case of Nix v. Hedden, a family business run by John Nix and his three sons was engaged in importing tomatoes from the Caribbean into the US, and the case involved their protest over being charged a tariff of 10% levied against all imported vegetables.

Such tariffs are enacted to protect domestic growers who want to charge higher prices and don't want to have to compete in a free market, and who use the government to pass laws harming their potential competitors. As this case shows, those competitors are not always citizens of other countries but also US citizens who are trying to make a living, such as the Nix family who had the bright idea of importing tomatoes that would be less expensive than domestic tomatoes. We point this out not because we think it is ok to harm businessmen from other countries, but rather because the supporters of such tariffs usually bill them as a measure against "foreign competition," implying that they think using the law to prevent competition is just fine as long as it only hurts "foreigners."

The Nix family paid the 10% tariff on their shipments, under protest, and then appealed the case on the grounds that tomatoes were actually a fruit (which is true). The Supreme Court unanimously ruled that although tomatoes actually are a fruit under the botanical definition, "As an article of food on our tables, whether baked or boiled, or forming the basis of soup, they are used as a vegetable" and, it was added, "not, like fruits generally, as dessert." Case closed, the tariff stands, and the Nix family has to pay extra money in order to make it impossible for them to sell foreign-grown tomatoes at a lower price.

The NPR narration of this ugly case completely glosses over the fact that one group is using the law to squash the livelihood of another group, and that consumers in general are the ones who end up suffering as well, since they have to pay the higher prices that result when competition is artificially blocked and less expensive sources are arbitrarily charged more because a product was more commonly used in a soup than in a dessert.

In fact, the narrator displays the common ignorance of free market principles often found on NPR* when he declares during his narrative that in this case "tomato growers had an interest in a tomato being declared a fruit" (at about 2:00 into the narrative). By saying this, Mr. Keillor has missed the point entirely! The tomato growers in the US had an interest in the tomato being declared a vegetable, so that they could be protected from outside competition from other growers: the tariff was enacted only on vegetables, and the Nixes wanted to prove the tomato a fruit so that they could import tomatoes from the Caribbean into the US to compete on price.

This may seem like a funny little sidelight of history with an amusing angle on vocabulary, but it is actually yet another example of the damaging effect of government barriers on free trade (which are almost always erected in order to artificially protect one group from competition).

We have written about the damaging impact of such intervention before, including the ongoing tariffs on imported sugar, which keep sugar prices in the US artificially high and have led to the proliferation of high fructose corn sweetener in items that used to be sweetened with sugar, as well as the protectionist policies that kept foreign ships from helping in the cleanup after the Gulf oil spill last year.

We'd like to suggest that such policies deserve the proverbial shower of tomatoes that were thrown at awful stage performances during the 1890s, when Nix v. Hedden was taking place.

* For other examples supporting the allegation of general ignorance of economic principles on NPR, see also:
"There are some things that are just too important to be left to the free market?"

"Air Vulgaria"

"What Rube Goldberg could teach us about economics"

"Banker calls for a 'New Capitalism'"


"Government interference, unintended consequences, and Wall Street bonuses"

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Sector sloshing

As active professional investment managers (see track record and GIPS disclosures for Taylor Frigon Capital Management located here), we are sometimes asked why good managers ever experience any periods of relative underperformance?

To put it another way, why do managers who outperform over longer periods frequently experience shorter periods in which they lag the market -- as research has shown that well over 90% of long-term outperforming managers actually do for periods of as long as three years? For data supporting this assertion, see this previous blog post and this study entitled "Investor's Paradox -- All High-Performing Managers Underperform."

We believe that the reason for this paradox lies in the fact that in order to perform better than the overall market, an investor must own companies that are better than the overall market (see here and here for our views on the topic). However, while an investor is owning those companies and waiting for them to realize their business potential, short-term market players are often stampeding from one part of the market to another, and back again. In the process the prices of companies in the "popular" sector will go up faster when the herd is focused on them, only to drop again later when the herd stampedes somewhere else.

We have written about this phenomenon as well, such as in this post explaining why we do not follow the typical Wall Street practice of "sector rotation." Big investment firms will often rush from one sector to another in response to various signals that they perceive as favoring one sector over another. Whatever the "flavor of the month" happens to be, where the herd is rushing at that particular moment, those stocks will go up for a short period, and often more swiftly, than the sectors that the herd is currently rushing out of.

To illustrate this point, have a look at the data collected from an extensive survey of investment managers shown in the table above. The data is from the period between August 2005 and August 2006, but it illustrates behavior that is very typical for almost any one-year period on Wall Street. The first column shows the months, and the next column over shows the percentage overweight or underweight that the US portfolio managers surveyed were at that period in time with regards to one sector, technology.

For the month of December 2005, the managers were net 38% overweight in the technology sector. By February 2006, they had reduced their exposure to a net 32% overweight, then by April 2006 had reduced their exposure to a net 27% overweight. Then, very suddenly, they went to 0% net overweight in tech during the month of May 2006, followed by net underweight 5% in June 2006 and then underweight 15% in July and underweight 22% in August.

In other words, in six months, the managers surveyed swung from being 32% overweight in technology to being 22% underweight in the same sector! That's an enormous amount of investment dollars sloshing out of one sector in a very short period of time. Portfolio managers who tend to hold companies for longer periods of time (such as ourselves) would have seen their technology companies suffer as prices dropped in the vacuum of all those other investors stampeding somewhere else.

A logical question that might come to mind at this point is, "Why would you stay in a tech company if you realized that all the money on Wall Street was moving out of technology stocks that month? Why wouldn't you chase the herd, so that your technology names didn't underperform during those months?"

The answer to that very practical-sounding question is, "because nobody can do that effectively." It turns out that trying to chase the erratic stampeding of the market herd is a surefire recipe for long-term underperformance. The fact is that the herd will inevitably come thundering right back in some future time period, and that nobody is good enough to predict its endless motion year-in and year-out for very long periods of time (such as the thirty-year, forty-year, or even longer periods of time that an actual investor typically should be thinking about for his investing lifetime).

In fact, we would go even further and make an even more shocking argument. We believe that because trying to chase one sector or another on a month-to-month basis is such a losing proposition, that disciplined investors who own better-than-average companies over long periods of time will very possibly do better than the herd! That's right: it may turn out in the long run that not only is it possible to beat the market using active management (and we certainly believe that it is possible, as we argue here and here) but that over the long run it would be difficult not to!

We don't have empirical evidence that this is so, but we may think of a way to prove it in the future. In the meantime, we would advise investors to think about this information very carefully, and to avoid the common practice of sector rotation -- or as we might call it based on the data above, "sector sloshing."

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