Competitive Global Tax Structures As Major Investment Determinant

When you read economic articles from the mainstream media or from popular "experts", one would accrue two significant but misleading impressions:

1. governments are the sole entities that are engaged in trade (from discussions of trade imbalances)

2. low wages are the only criteria that ensures success or economic prosperity (from discussions of currency manipulation)

But of course, such discussions is far from the truth or reality.

Governments generally don't produce anything but generates its revenues by taxation. This means that people through various forms of enterprises, and NOT the government itself, are engaged in trade.

Next, investment is a function of returns: particularly, the rate of return on investments. Of course before establishing the rate of investments, the most important factor would be the return OF investments (via security of property rights).

In other words, expected profits (revenues-costs) determine investment activities.

In contrast to mainstream polemics, the fact is that wages constitute only one of the many variables that adds up to the long list of costs.

Yet there are other factors that determine the profitability of an enterprise among them: as stated above is the varying degree of property rights, different conditions of existing infrastructure, operational institutions, legal framework (which secures contracts and resolves disputes), cultural variables (traditions, superstitions etc.), security, political stability, capital and production structure, access to markets, access to raw materials, access to finance, degree of labor and skills available, education of the labor force, cost of energy, transportation and connectivity, quality of management, regulatory structure, transaction costs, tax policies, degree of economic freedom and etc...

Importantly these cost structures can be nuanced by the operating principles of the comparative advantage and specialization or the division of labor.

Yet all these very important variables are frequently ignored when arguments get oversimplified but cloaked with technical gobbledygook.

Below is an example of a more important factor that influences business activities.

It's about tax structures.

The chart taken from the Economist, highlights on the world's declining corporate tax rates.

The Economist with a tinge of demur from falling tax rates writes, (bold highlights mine)

``CORPORATE-TAX rates in OECD countries have fallen remorselessly over the past 30 years. A survey by Robert Carroll of American University in Washington, DC, found that the top rate in OECD countries (excluding America) had dropped from 51% in the early 1980s to 32% by 2009. Competition among countries to attract business and with it bring employment was fierce in the late 1990s and early 2000s. Ireland reduced its corporate-tax rate to just 12.5% and chose not to raise it last year during an emergency budget. Such differentials may not last long. High-tax European governments have complained in the past about competition from countries such as Ireland and the current economic crisis may lead to more calls for co-ordination of tax policies."

Of course, coordination of tax policies won't work. Competition among governments will still determine investments.

This from World Bank's Paying Taxes 2010

According to Doing Business 2010 (all bold and italics emphasis mine)

``The size of the tax burden on businesses matters for investment and growth. Where taxes are high and corresponding gains seem low, the incentive for businesses to opt out of the formal sector increases.

``A recent study shows that higher tax rates are associated with lower private investment and fewer formal businesses. A 10 percentage point increase in the effective corporate tax rate is associated with a reduction in the ratio of investment to GDP of up to two percentage points and a decrease in the business entry rate of about one percentage point. Other research suggests that a one percentage point increase in the statutory corporate tax rate would reduce the local profits of existing investments by 1.31 percentage points on average and lead to an 18 percentage point increase in average debt-to-asset ratios (part of the reason for the lower reported profits). A one percentage point increase in effective corporate tax rates reduces the likelihood of establishing a subsidiary in an economy by 2.9 percentage points.

``Besides the taxes paid, there are costs of complying with tax laws and of running the revenue authority. Worldwide on average, a standard small to medium sized business still spends three working days a month complying with tax obligations as measured by Doing Business. Where tax compliance imposes heavy burdens of cost and time, it can create a disincentive to investment and encourage informality. Particularly in developing economies, large informal sectors contribute to the creation of an uneven playing field for formal small and medium sized enterprises, squeezed between smaller informal competitors and larger competitors whose greater resources can help win a more effective audience with government and thus greater tax concessions."

``Worldwide, economies that make paying taxes easy tend to focus on lower tax rates accompanied by wider tax bases, simpler and more efficient tax administration and one tax per tax base. They also tend to provide electronic filing and payment systems, which reduce the tax burden for firms while lightening their administrative requirements."

So as the multilateral government institution World Bank points out, tax rates juxtaposed with tax and regulatory compliance plays a major role in the shaping of trade balances among nations and in domestic economic development.

The sub-Saharan Africa has the highest tax rates around the world along with dubious recognition for property rights and mired with political instability ,which offsets its lowest wage framework, hence remains the least attractive venue for investors which has stagnated their economies.

On the other hand, the reasons why Asia and many Emerging Markets has been generating increasing investments is due to the relative advantage of their tax structures.

As we said above competition among governments will ascertain the flow of investments and the recent bubble bust just drove a wedge between responsible and profligate governments.

To wit, the responses by the OECD governments to the recent bubble bust is likely to amplify these differences: higher taxes-lower return for OECD economies as against lower taxes-higher return for Asia and emerging markets.

Guess where investments will flow to?

Falling Global Trade Equals Rising World Hunger

The Economist recently published a chart depicting the rising incidence of hunger in the aftermath of last year's financial crisis.

According to The Economist, (all bold emphasis mine)

``THE economic crisis is having a big impact on those already struggling to survive. The number of chronically hungry people in the world will rise from 913m in 2008 to 1.02 billion this year, a sixth of the global population, says the UN's Food and Agriculture Organisation in its annual report on food insecurity. Food prices that are 17% higher than they were two years ago, and big falls in remittances and investment are contributing to growing hunger. The economic slump has meant a growing share of the world's population is going hungry, after a steady decline since 1970. And the FAO notes that global food output will have to increase by 70% to feed a population projected at 9.1 billion in 2050."


I think The Economist has painted only a minor part of the big picture.

It is true remittances are expected to decline to about $290 billion in 2009 from only $305 billion in 2008, according to Indiainfo.com., and possibly contribute to the hunger woes. The Chart of global remittance trend above from UNCTAD Trade and Development Report.


But remittances are puny compared to what matters more.

The Economist have significantly missed the most important aspect- the impact from the $32 trillion global trade. From this perspective remittances constitute only 9% of global trade.

Yet, the material improvement of world hunger has coincided with a surge in global trade similar to the impact on depressed gold prices in the 90s as explained in Gold: An Unreliable Inflation Hedge?

While investment matters too, this has likewise mostly been underpinned by globalization trends.

In short, global trade creates job opportunities, expands the global labor market and improves on per capita GDP as to reduce poverty and incidences of hunger.

On the other hand, food prices are largely determined by trade, investments incentivized or hindered by national administrative policies and importantly, current synchronized monetary policies to curb so called demand shock from last year's meltdown.

Policies aimed at resolving such demand shock, with an overdose of paper money with dead politicians printed on them, may spawn a "supply shock" or a food crisis.

Debating The Fate Of The US Dollar, A Gold Linked Currency And China’s Yuan

In view of the falling US dollar, many articles have emerged to defend the US dollar as being either irreplaceable or will become substitutable only after a defined period of years or the Chinese yuan may follow the unsuccessful attempt of the Japan yen to emulate the US dollar as reserve currency or of inapplicability of a gold linked currency in today’s paper money standard.

While they maybe correct, I inclined to think many of these have been relying heavily on past performances and projecting these into the future.

Debating The Fate of the US dollar

For me the issue of the continued privilege of the US dollar as reserve currency will depend on the extent of inflationary policies imposed by its government, and secondly, from the responses of the world to such policies.

Next, the US dollar hasn’t been stable relative to its purchasing power. The fact that it has declined by 95% since 1913, makes it “stable” in terms of the rate of purchasing power lost over the years.

Perhaps the US dollar could be seen as “stable” in relative terms, or against other currencies, as paper currencies in general continue to collectively suffer from eroding purchasing power based on the continued abuse of the elastic currency due to sundry political goals.

Moreover, given mercantilist tinge by many of the world’s central bankers who continue to embrace “cheap currencies for exports” mindset via the imposition of varying degree of exchange rate pegs, assorted subsidies and tariffs and other proscriptions, a global campaign for “competitive devaluation” could lead to a currency war.

To quote, Murray N. Rothbard, in Making Economic Sense, ``The whole world would then be able to inflate together, and therefore not suffer the inconvenience of inflationary countries losing either gold or income to sound-money countries. All the countries could inflate in a centrally- coordinated fashion, and we could suffer manipulation and inflation by a world government-banking elite without check or hindrance. At the end of the road would be a horrendous world-wide hyper-inflation, with no way of escaping into sounder or less inflated currencies.” (bold emphasis mine).

So again we shouldn’t see this as analyzing against a constant but of an action-reaction dynamics to evolving policies. Say for instance if the US will see an upsurge in inflation will global governments continue with the current setup?

My guess is no.

A Gold Link Currency In Today’s Fiat System?

Another, currency volatility has been due to too much distortion brought about by government interventions in the economic system.

A country which adopts a gold standard may indeed be destined to see its currency’s price swings based on gold’s price performance.

However, what must be understood is that the accompanying fiscal restraint brought about by adapting a gold-linked currency system will probably lead to an appreciation based on significantly less politicization of the nation’s political economy that could lead to a productivity spike.

Nonetheless currency values will always fall under natural law of demand and supply, as Ludwig von Mises in Theory of Money and Credit wrote, ``the valuation of the monetary unit depends not upon the wealth of the country, but upon the ratio between the quantity of money and the demand for it, so that even the richest country may have a bad currency and the poorest country a good one. (emphasis added)

This leads us to international trade, currency values aren’t everything; weak currencies don’t necessarily imply export strength, for instance Philippine exports plunged by 25% in July in spite of the underperforming Peso (Inquirer), whereas strong currencies don’t automatically translate to feebleness in exports, for example Europe registered a surplus on “strong exports” in July in spite of the steep appreciation of the Euro (google).

What would crucially matter is the market from which a producer of goods or services sells into, the capital structure of an economy and importantly policies that underpin the trade structure, as discussed in Asia: Policy Induced Decoupling, Currency Values Aren’t Everything.

But of course, a gold linked currency given today’s political setting and economic ideological framework isn’t likely to be in the cards for policymakers, simply because it is not politically appealing. A gold backed currency would restrain politicians from taking advantage of the easiest, least understood and most discreet form of wealth redistribution.

China’s Remimbi As International Reserve?

Finally past performances don’t equate to future outcome.

Figure 2: Wall Street Journal: Yen Denominated Trade Transactions

The Yen’s failure to emulate the US dollar as a reserve currency, see figure 2, doesn’t necessarily extrapolate to the destiny of the Chinese Yuan. The circumstances behind the Yen’s unsuccessful attempt are not exactly the same forces faced by the Chinese today.

Becoming an international reserve standard would depend on many factors that would make a currency accepted as an international store of value, unit of account and medium of exchange, such as convertibility, market economy, depth and sophistication of the financial markets, transparency, low transaction costs, military might and etc…

Nevertheless, one good starting ground is by way of marketability.

Again Murray Rothbard in What Has Government Done To Our Money, ``Now just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media--in almost all exchanges--and these are called money.” (bold highlights mine)

The degree with which China would assimilate a market economy will serve as the pivotal fundamental steps towards achieving such a goal.

Nonetheless, again it will also depend on the underlying policies that China would be undertaking aside from the policies by the US government as the de facto currency reserve and of the world relative to China.

It’s a complex and a highly fluid issue to speculate on.

Will China’s Stock Market Correction Spread Globally?

``We have seen that according to popular thinking, an asset bubble is a large increase in asset prices. A price is the amount of dollars paid for a given thing. We may just as well say, then, that a bubble is a large increase in the payment of dollars for various assets. As a rule, in order for this to occur there must be an increase in the pool of dollars, or the pool of money. So, if one accepts the popular definition of what a bubble is, one must also concede that without an expansion in the pool of money, bubbles cannot emerge. If the pool of money is not expanding, then people — irrespective of their psychological disposition — simply do not have the ability to generate bubbles in various markets.” Frank Shostak, How Can the Fed Prevent Asset Bubbles?

It looks likely that we may have reached a turning point for this cycle.

I’m not suggesting that we are at the end of the secular bull market phase, but given the truism that no trend moves in a straight line, a reprieve should be warranted.

To consider, September and October has been the weakest months of the annual seasonal cycle, where most of the stock market “shocks” have occurred. The culmination of last year’s meltdown in October should be a fresh example.

Although, this is not to imply that we are about to be envisaged by another crisis this year (another larger bust looms 2-4 years from now), the point is, overstretched markets could likely utilize seasonal variables as fulcrum for a pause-or a window of opportunity for accumulation.

A China Led Countercyclical Trend

My case for an ephemeral inflection point is primarily focused on China.

Since China’s stockmarket bellwether, the Shanghai Index (SSEC), defied “gravity” during the predominant bleakness following last year’s crash, and most importantly, served as the inspirational leader for global bourses, its action would likely have a telling impact on the directions of global stock markets.

In short, my premise is that global markets are likely to follow China.

True, the SSEC had a two week correction, which have accounted for nearly 11% decline (as seen in Figure 1) but this has, so far, been largely ignored by global bourses.

Figure 1: Stockcharts.com: The Shanghai Index Rolling Over

Nevertheless, the action in China’s market appears to weigh more on commodities on the interim. This should impact the actions in many commodity exporting emerging markets.

The Baltic Dry Index (BDI) which tracks international shipping prices of various dry bulk cargoes of commodities as coal, iron ore or grain has been on a descent since June.

This has equally been manifested in prices Crude oil (WTIC) which appears to have carved out a “double top” formation.

In short, there seems to be a semblance of distribution evolving in the China-commodity markets.

The possible implication is perhaps China’s leash effect on global stock markets will lag.

From a technical perspective, using the last major (Feb-Mar) correction as reference, a 20% decline would bring the SSEC to a 50% Fibonacci retracement, while a 25% fall would translate to 61.8% retracement.

And any decline that exceeds the last level may suggest for a major inflection point, albeit technical indicators are never foolproof.

Moreover, from a perspective of double top formation in oil; if a breakdown of the $60 support occurs then $49-50 could be the next target level.

As a reminder, for us, technicals serve only as guidepost and not as major decision factors. The reason I brought up the failure in the S&P 500 head and shoulder pattern last July [see Example Of Chart Pattern Failure] was to demonstrate the folly of extreme dependence on charts.

As prolific trader analyst Dennis Gartman suggests in his 22 Trading rules, ``To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.”

In short, understanding market sponsorship or identifying forces that have been responsible for the actions in the marketplace are more important than simple pattern recognition. Together they become a potent weapon.

So despite the recent 11% decline of the SSEC, on a year date basis it remains up by a staggering 67%.

Politicization Of The Financial Markets

Some experts have suggested that when global stock markets would correct, such would transpire under the environment of a rising US dollar index, since this would signal a liquidity tightening.

I am not sure that this would be the case, although the market actions may work in such direction where the causality would appear reflexive.

Unless the implication is that the impact from the inflationary policies has reached its pinnacle or would extrapolate to a manifestation of the eroding effects of such policies, where forces from misallocated resources would be reasserting themselves, such reasoning overlooks prospective policy responses.

The US dollar index (USD) has recently broken down but has been drifting above the breached support levels (see above chart).

It could rally in the backdrop of declining stock markets and commodity prices, although it is likely to reflect on a correlation trade than a cause and effect dynamic.

By correlation trade, I mean that since the markets have been accustomed or inured to the inverse relationship of the US dollar and commodities, any signs of weaknesses in the commodities sphere would likely spur an intuitive rotation back into the US dollar.

Some may call it “flight to safety”. But I would resist the notion that the US dollar would represent anywhere near safehaven status given the present policy directions.

However, if the US dollar fails to rally while global stocks weaken, then any correction, thus, will likely be mild and short.

So yes, the movement of the US dollar index is an important factor in gauging the movements of the global stock markets.

But one must be reminded that last year’s ferocious rally in the US dollar index was triggered by a dysfunctional global banking system when the US experienced a near collapse prompted by electronic “institutional” bank run.

This isn’t likely to be the case today.

So far, aside from the seeming “normalization” of credit flows seen in the credit markets, our longstanding premise has been that global authorities, operating on the mental and theoretical framework of mainstream economics, will refrain from exhausting present gains from which have been viewed as policy triumph.

Hence our bet is that they will likely pursue the more of the same tact in order to sustain the winning streak. The latest US FOMC transcript to maintain current policies could be interpreted as one.

Why take the party punch bowl away when the financial elite are having their bacchanalian orgy?

As we noted in last week’s Crack-Up Boom Spreads To Asia And The Philippines, ``Where financial markets once functioned as signals for economic transitions, it would now appear that financial markets have become the essence of global economies, where the real economy have been subordinated to paper shuffling activities.”

Where policymakers inherently sees rising financial assets as signals of economic growth, the reality is that most of the current pricing stickiness has been fueled by excessive money printing that has prompted for intensive speculations more than real economic growth.

Figure 2: New York Times: Hints of a Rebound in Global Trade?

For instance, Floyd Norris of the New York Times has a great chart depicting the year on year changes of global trade based on dollar volume of exports.

While there has indeed been some improvements coming off the synchronized collapse last year, the growth rates haven’t been all that impressive.

In short, rapidly inflating markets and a tepid growth in the global economy manifest signs of disconnect!

Yet global policymakers won’t risk the impression that economic growth will falter as signaled by falling financial asset prices. Hence, they are likely to further boost the “animal spirits” by adopting policies that will directly support financial assets and hope that any improvements will have a spillover effect to the real economy via the “aggregate demand” transmission mechanism.

Alternatively, one may interpret this as the politicization of the financial markets.

To give you an example, bank lending in China has materially slowed in July see figure 3. This could have accounted for the recent correction in the SSEC.

Figure 3: US Global Investors: Declining Bank Loans

According to US Global Investors ``China’s new lending data for July may be a blessing in disguise, as the slowdown can partly be attributed to a sharp month-over-month decrease in bill financing. Excluding bills, July’s new loans to companies and households were comparable to May and higher than April. With more higher-yielding, long-term loans replacing lower interest-bearing bill financing, margins at Chinese banks should improve as long as corporate funding demand remains strong and overall loan quality stays healthy.”

While this could be seen as the optimistic aspect, the fact is that aside from the overheated and overextended stock markets, property markets have likewise been benefiting from the monetary shindig- property sales up 60% for the first seven months and where residential investments “rose 11.6 percent, up from 9.9 percent in the six months to June 30” “powered by $1.1 trillion of lending in the first six months” (Bloomberg)

True, some of these have filtered over to the real economy as China’s power generation expanded by 4.8% in July (Finfacts) while domestic car sales soared by 63% (caijing) both on a year to year basis.

So in the account of a persistent weak external demand, Chinese policymakers have opted to gamble with fiscal and policies targeted at domestic investments…particularly on property and infrastructure.

Remember, the US consumers, which had been China’s largest market, has remained on the defensive since they’ve been suffering from the adjustments of over indebtedness which would take years (if not decades) to resolve (see figure 4).

Figure 4: Danske Research: US Consumers In Doldrums

And since investments accounts for as the biggest share in China’s economy, as we discussed in last November’s China’s Bailout Package; Shanghai Index At Possible Bottom?, ``the largest chunk of China’s GDP has been in investments which is estimated at 40% (the Economist) or 30% (Dragonomics-GaveKal) of the economy where over half of these are into infrastructure [30.8% of total construction investments (source: Dragonomics-Gavekal)] and property [24% of total construction investments]”, the object of policy based thrust to support domestic bubbles seem quite enchanting to policymakers.

Besides, if the objective is about control, in a still largely command and control type of governance, then Chinese policymakers can do little to support US consumers than to inflate local bubbles.

Aside, as we discussed in last week’s The Fallacies of Inflating Away Debt, “conflict-of –interests” issues on policymaking always poses a risk, since authorities are likely to seek short term gains for political ends or goals.

From last week ``policymakers are likely to take actions that are designed for generating short term “visible” benefits at the cost of deferring the “unseen” cumulative long term risks, which are usually are aligned with the office tenure (let the next guy handle the mess) or if they happen to be politically influenced by the incumbent administration (generates impacts that can win votes)”

In China, political incentive issues could be another important variable at work in support of bubble policies.

Michael Kurtz, a Shanghai-based strategist and head of China research for Macquarie Securities Michael Kurtz, in an article at the Wall Street Journal apparently validates our general observation.

From Mr. Kurtz (bold highlights mine),

``…far from being an accidental consequence of loose monetary policy, stand out as the purpose of that policy. The fact that housing construction must carry so much of the growth burden means policy makers likely prefer to err well on the side of too much inflation rather than risk choking off growth too early by mistiming tightening.

``Meanwhile, China's political cycle may exacerbate risks of an asset bubble. President and Communist Party Chairman Hu Jintao and other senior leaders are expected to step down at the party's five-year congress in October 2012. Much of the jockeying for appointments to top jobs is already under way, especially for key slots in the Politburo. Mr. Hu will want to secure seats for five of his allies on that body's nine-member standing committee, ensuring his continued influence from the sidelines and allowing him to protect his political legacy.

``This requires that Mr. Hu deliver headline GDP growth at or above the 8% level that China's conventional wisdom associates with robust job creation, lest he leave himself open to criticism from ambitious rivals. The related political need to avoid ruffling too many feathers in China's establishment also may incline leaders toward lower-conflict approaches to growth, rather than deep structural reforms that would help rebalance demand toward sustainable private consumption. Easy money is less politically costly than rural land reform or state-enterprise dividend restructuring. This is especially the case given that much of the hangover of a Chinese asset bubble would fall not on the current leadership, but on the next.”

So the “window dressing” of the Chinese economy for election purposes fits our conflict of interest description to a tee!

Overall, it would seem like a mistake to interpret any signs of a prospective rally in the US dollar on “tightening” simply because policymakers (in China, the US, the Philippines or elsewhere) are likely to engage in more inflationary actions for political ends (policy triumph, elections, et. al.).

Hence, any signs of market weakness will likely prompt for more actions to support the asset prices.

Has World Trade Been Picking Up?

Yes, according to Businessweek.

Chart from Panjiva

This from Businessweek's Joe Weber,

``In yet another sign that some key players are acting as if recession is on the run, more offshore manufacturers are shipping goods into the consumer-driven U.S. market, global-trade tracker Panjiva reports. The May trade data mark the third consecutive monthly rise in the number of shippers moving such goods, the first such Trifecta since the firm began following this metric in July 2007.

``“Increasingly, it feels that the worst is behind us,” says Josh Green, chief executive officer of the trade-tracking firm. Waxing cautious, however, he adds “Still, we have a long way to get back to the pre-crisis level of global trade.”

``Nonetheless, the data, released June 16, suggest that global trade has hit bottom and is taking the first steps toward recovery. Some 131,688 suppliers were active in May, up 2% from the number in April. The rises in shipper tallies give the Panjiva analysts heart, since such totals have been sliding since at least July 2007, when they counted 161,905 shippers moving goods into the U.S.

``The analysts point to other barometers of improvement, too. The percentage of significant manufacturers on a watch list – those in danger of going out of business – dropped a percentage point to 30% in May, for instance. This marked the first such decline since Panjiva started tracking this metric last September."

Read the rest here. (Hat tip: Mark Perry)

The recent rise in the Baltic Dry Index, commodities (CRB) and oil could be partly be due to this.

Nevertheless, our take has been that the collapse in global trade was mainly a consequence of the seizure "shock" in the US banking system which virtually shackled global trade flows by constricting access to financing.

Although the paradigm which underpinned the past boom won't be revived, present signs of recovery could have been due to the replenishment of inventory destocking.

As for how sustainable this would be remains to be seen.