By Victor Sperandeo
You can thank our “Dear Leader” President Obama and his politburo of congressional majorities for the upcoming increase in capital gains taxes for hedge funds and venture capitalists on what is known as carried interest. I predict this will cause unemployment to go from a stated rate of 9.5% to at least 12%!
This is an issue of economics, not ideology. What is best to create jobs and growth in real GDP? This should not be about changing capitalism and a free economy into a communist-like state. On March 2, 2009, President Obama was quoted in Barron’s saying that his administration had inherited a “legacy of misplaced priorities” resulting in a three-decade-long trend of rising income inequality. In a free country, some income inequality is guaranteed. It has to occur!
The real question to ask is: Will higher capital gains taxes, targeted at the providers of capital, help create jobs? The answer is a definite NO! To assume that risk-takers will not change their behavior based on higher taxes (and therefore lower returns) is mathematically impossible.
To an issuer of stock, what does the price of a stock represent? Primarily it is the cost of capital. The higher the price (and/or the higher the multiple), the cheaper the cost of raising capital by the issuer (assuming the same number of shares outstanding), and thereby the cheaper the profit margins needed to create more profit opportunities. Those profits then allow the companies to grow, and to hire new workers, build new plants, and expand their businesses. For example, in December 2006 Citigroup stock was trading above $56 a share. Today it is around the $4 level, which means it is 1400% more expensive for Citigroup to raise capital through equity. Thereby, it is an axiom to say high stock prices are better than low ones for the issuers.
Hedge funds are net buyers of stocks, and help share prices rise, all else being equal. When you raise the net cost of investment for hedge funds and venture capital firms, whether by higher capital gains taxes or some other mechanism, you alter the risk/reward ratios. Any investment which suddenly offers less net reward, even if successful, becomes less attractive to create or fund. There will be fewer buyers of stocks, which results in lower share prices and lower valuations (meaning higher costs) and thereby fewer new jobs and less real growth.
This is mathematical, not philosophical. The minds that propose and pass these increases do so for ideological reasons, not to create jobs. Either that, or they have no understanding of the basic tenets of business and investment. They must believe investors will simply be willing to accept less reward for risking their capital without changing their investment practices.
As I mentioned, the general liberal economic answer to raising taxes is that hedge funds will invest anyway. That is, they will not change their behavior. Those who believe this have never understood the concept of risk/reward. If you ask a casino owner to lower the odds of the house’s edge at roulette to 2% versus 6% in the name of fairness, you must realize that the cost of operating the business will no longer be covered, and it will eventually close. All the workers will be fired but in theory fairness prevailed.
To run a hedge fund or venture capital firm is expensive. It requires expensive lawyers, accountants, analysts, traders, and a growing cost to comply with the government regulations that are being piled onto such businesses. The investments these firms make are not some kind of non-risk wage for time that most people earn. Each investment carries with it a risk of partial or total loss. Just examine the dot com bubble and the housing bubble. Many businesses failed, and with them jobs were lost. But those jobs never would have existed if not for the willingness of investors to accept the risk, in the hopes of a reward commensurate with the risk taken. In 2008, hedge funds lost an average of more than 20%. To raise taxes on these firms is going to eliminate jobs or keep the jobs from every being created.
Capital gains are the appreciation in the value of an asset, which is discounted to the present value of the after-tax cash flow. Therefore if “the methods of taxation…bring about capital consumption or restrict the accumulation of new capital, the capital required for marginal employments is lacking and an expansion of investment which would have been effected in the absence of these taxes is prevented. The wants of the consumers are satisfied to a less extent only. But this outcome is not caused by a reluctance of capitalists to take risks; it is caused by a drop in capital supply.” Such were the observations of Ludwig Van Mises, leader of the Austrian School of Economics, over 60 years ago.
On one hand, the altered risk/reward numbers will cause fewer businesses to be formed, and on the other the ones that do start will be taxed at higher rates as capital is consumed by government for political favors and handouts. This ideology is all caused by envy, not by the economics that help the United States as a whole. Socialist fascists and communists argue that lower taxes result in lower overall spending, but this is just their excuse to engage in Keynesian economic policies. The belief is corporations invest when people spend. If the government takes from those who earn more than they spend, the goal is to take capital from those sources and make sure it is spent elsewhere. This causes investment only in the minds of liberal academics.
Lastly what are stock prices for the buyer? When stock prices increase, wealth is created, and thereby spending rises. This occurs with lower taxes in most environments. The most-used rare example of a supposed exception is Clinton’s reign, which suggests that he raised taxes in 1993 and growth occurred. Actually, the growth was caused by innovation: widespread use of the internet, cell phones, laptop computers, and more…and was perpetuated with artificially low interest rates that eventually led to the housing bubble. To believe that raising taxes caused growth is not reality. It’s politically motivated.
Raising taxes on investment and capital hurts the lower and middle classes most of all. The wealthy can simply choose not to invest, and not to risk their capital, and spend their time sunning on the beach instead. In the meantime, the working classes are left with no new jobs, and no new opportunities to someday reach their goals of more financially comfortable lives.
Victor Sperandeo is president and founder of two Dallas firms: EAM Partners, a discretionary trading firm, and Alpha Financial Technologies, which creates computerized, investible futures algorithms. He is the author of “Trader Vic: Methods of a Wall Street Master,” “Trader Vic II: Principles of Professional Speculation,” and “Trader Vic on Commodities: What’s Unknown, Misunderstood and Too Good To Be True.”