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Mark's Market Blog

4-24-10: Inflation and Taxes: All Hail the VAT!

By Mark Lawrence

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The markets rebounded from the news that Goldman was Evil (Who Knew???). They rebounded in a very interesting way: in the chart below, we see that the market bounced twice off the 20-day moving average (green line): the 20-day SMA proved a floor on market values. How long can this hold up? What happens when a leg pokes through the floor? For the answers to these and other pressing concerns, stay tuned to your local blog channel.

S&P 500 November 1 2009 to April 23 2010

Hojatoleslam Kazim Sadeghi, a senior cleric who was appointed last year by Iran's Supreme Leader Ayatollah Khamenei, said women and girls who "don't dress appropriately" spread "promiscuity in society. When promiscuity spreads, earthquakes increase." And these are the people who need a nuclear bomb.

Moody's downgraded its bond ratings on Greek debt. Yields on 2-year Greek debt topped 10% for the first time since 1999, the euro approached a 1-year low vs. the dollar and a global stock sell off spilled over in the U.S. markets. If Greece were allowed to default on its debt it would call into question the long-term viability of the euro and raise more concern about Europe's other so- called PIIGS: Portugal, Ireland, Italy and Spain. Meanwhile, Greek civil servants were staging a 24-hour strike. "Greece seems to be headed to a debt restructuring where haircuts are going to have to be taken as its impossible for their economy to grow out of their debt obligations," writes Miller Tabak strategist Peter Boockvar. "The euro zone cannot guarantee Greek debt as who would buy a German bund yielding 3.05% when you can buy German-guaranteed Greek debt at 8.5%?"

The amount of junk in low Earth orbit -- where the shuttle and the space station travel -- has increased 60 percent since 2006, according to NASA. Recent additions to the trash belt include 3,000 pieces of debris created last year when China destroyed a defunct satellite as a test of anti-satellite military capability, and 2,000 more bits that came from a collision this February between an Iridium commercial satellite and a dead Russian satellite.

William Jeffs, NASA spokesman for the Astromaterials Research and Exploration Science Directorate at the Johnson Space Center in Houston, said the millions of pieces of space junk include half a million pieces bigger than a marble and 20,000 bigger than a softball.

There's some new studies of low earth orbit (LEO), and they indicate an interesting result: as the amount of junk increases, the likelihood of an impact increases. An impact between one satellite and one piece of space junk can release hundreds or thousands of new pieces of space junk, a little like an out of control atomic chain reaction. It turns out there's a critical density of space junk; when you get to that density, all the satellites quickly get destroyed and the junk grows exponentially. Current estimates are that we're within a factor of 2 to 5 of the critical density - just a little bit more and LEO will be ruined for everyone for a couple hundred years. This will have a major impact on the space station, communications, spy satellites, GPS, and even the Hubble and other space telescopes. Pretty much all that would be left are geosynchronous satellites like DirecTV - you won't know where you are, you won't be able to make a long distance call with your iPhone, but you'll be able to watch Desperate Housewives and Sex in the City on its tiny screen.

Where do your tax dollars go? Here's a chart by state of the return on each dollar send to Washington. Light blue are the ten states that get the worst deal, dark blue the ten that get the best deal.

Federal payouts per tax dollar by state

In the '60s and '70s the baby boomers (which embarrassingly includes your intrepid author) informed our elders that their materialistic consumption-oriented religious but anti-spiritual society was going to have to go and be replaced by something far more enlightened. How did we do? Divorce has sky-rocketed, out-of-wedlock births are now the norm, and personal consumption as a fraction of GDP is up by 20%. However, we all know how to meditate and spell "Buddhist." And we're all worried that our Lexus will get a stuck throttle or roll over.

US Personal Consumption 1960 to 2010

As we've seen, unemployment is very high and likely to stay very high for a long time; we've laid off a bunch of low-skill people and are replacing them with low-wage people in 3rd world countries. In the current recovery "productivity" is growing at a great clip: +6.9% annualized in Q4 2009 alone. Productivity gains mean fewer people are making the same amount of stuff. This is very good for profits, but very bad for unemployment.

US Productivity 2004-2009

Europe is having exactly the same problem, not enough work to keep everyone busy. There are two possible answers to this: get consumers to spend more, requiring more stuff to be made, or export more, requiring more stuff to be made. The easiest way to export more is to devalue your currency, making imports more expensive and exports cheaper. The result of this is we're in a race to the bottom. So far this year the Euro and the Pound are dropping in value nearly every week, hoping to sell more stuff to others, basically exporting unemployment and importing jobs. Some predict that this will continue until $1 = €1 = £1. If this happens, US exports to Europe will basically dry up, and we will be on our own once again to create jobs and demand for the entire world. But what if we don't this time? Europe may have to finally face the fact that their expensive social welfare states are going to bankrupt them. Europe's history as a manufacturer is not very positive. In the chart below, we see that the US, China, Japan and Germany manufacture things, everyone else just sells hamburgers.

Manufacturing by Country, 1970 to 2009

Shelter is 40% of CPI, so Government intervention in the housing market has distorted the inflation numbers. By inducing people to buy homes, the rental rates are being depressed. To date, about 2 million Americans have applied for the first-time home buyer tax credit; with that many former renters becoming homeowners, demand for rental properties has softened. The other 60% of the CPI has been in an up trend since last summer. Shelter costs are calculated in the CPI by using "owner's equivalent rent" instead of actual house prices, so falling rents are making the Fed look good.

US Inflation 2008 through 2009

Inflation is important because this tells us when the Fed will have to raise interest rates, pulling the punch and guacamole off the party table. The Fed has been funding the current expansion by buying, well, everything - treasury bonds, mortgage bonds, and gold Rolexes for everyone at Goldman Sachs. Absent the Fed's buying spree, interest rates would already be climbing, the housing market would be a dead rat in the streets, and interest on the US National Debt would already approaching panic territory.

US Federal Reserve Balance Sheet 2007 through 2009

When you couple the growing productivity-fueled expansion and higher profits with growing inflation, it seems obvious the FED will be raising rates sometime kindof soon - certainly this year, I would think. This will raise the interest costs on the national debt and increase the budget deficit. Interest on the national debt is already about a quarter of the federal budget, this is only going to climb. Washington is going to get squeezed.

US Federal Budget Deficits 1990 - 2040

We all know that in the long run, Washington is going to have to raise taxes. But which taxes? Raising the income tax is unpopular, and it's unthinkable that they can raise it anywhere near enough to plug the deficit gap. Raising payroll (social security) taxes is always popular and will certainly happen, but how far can that go?

US Federal Tax Revenue by Tax Type

The US corporate tax rate is already one of the highest in the world, and in the next few years when Washington starts raising taxes on most everyone, imagine them trying to sell lowering the corporate rate. But if they don't, more jobs will continue to move to lower cost countries.

Corporate Taxes by Country

Raising taxes is suddenly popular in Washington. For decades this country has believed that higher taxes = lower growth. Even Obama's economists have concluded that Tax changes have very large effects: an exogenous tax increase of 1 percent of GDP lowers real GDP by roughly 2 to 3 percent. Of course this view cannot go unchallenged, as Washington must raise taxes or stop buying votes. So, the talk now is that the economists are wrong, and high taxes go along with high growth rates in lots of countries.

Tax Rates v. GDP Growth Rate

Where will this wind up? I think it's obvious that in the coming decade, Washington will give us the VAT - Value Added Tax. This will be sold as a national sales tax, with a rate somewhere around 5% to start. However, this tax is different from a sales tax. When you buy something for $100, you pay $108, the $8 is sales tax and is visible. However, VAT is distributed in such a way that it's hidden. As a businessman, when I buy materials the VAT will already be added into the materials. When I sell a product, the VAT I pay is a percentage of the sale price of the product less my expenses: marketing and materials. What's left? Payroll and my profits; since my profits are my pay check, I see the VAT as an employment tax. You will see the VAT as prices going up, but as we'll likely have inflation at the same time this won't seem like much.

Last week we saw that efficient taxes like the payroll tax only ever go up. VAT is the most efficient tax ever invented by mankind. In the future, every time we get a group like the current Congress that wants to spend money on free entitlements for the masses (legal or illegal), they will simply raise the VAT by 1% or 2% and Shazamm, there's the money.

The VAT is the next, and basically last step to turn us into a European social welfare state, Eurosclerosis and all.

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