Because of aging populations, many governments will need higher tax revenues. But technology and globalization are making it more difficult to raise taxes.
It would be easy to dismiss actor Gerard Depardieu’s move to Belgium to avoid France’s new 75% marginal income tax rate as an isolated and inconsequential event, but it would probably be an incomplete assessment. Depardieu’s decision should also be seen as a signal development for tax authorities everywhere. There is an evolving reality in the world which is that wealth and the wealthy have become more mobile than ever before. Therefore, both wealth and at least some of the wealthy will migrate to the friendliest taxing jurisdictions, putting limits on governments’ ability to tax their citizens.
Most people would not move themselves and their families for the sole purpose of lowering their tax bill, but some will. If these ‘some’ include a few of our generation’s biggest innovators, their migration could determine which countries prosper and which stagnate or decline. Against a backdrop of rising dependency ratios (fewer workers per dependent), governments in developed countries face an intractable dilemma. On one hand, they will need more tax revenues to extend social services to their aging populations. On the other hand, the world’s most productive people and biggest tax contributors may choose to move or settle elsewhere.
Exhibit One of what is now known in France as l’Affaire Depardieu is the increased mobility of the wealthy. Warren Buffett wrote that the very high marginal tax rates of the 1950s and 1960s were no deterrent to investment, employment and growth. But back then the United States was pretty much the only game in town, with Europe and Japan still recovering from World War II, and the rest of the world mired in war, repression, poverty or political instability. The brain drain was still working exclusively in America’s favor.
Blame it on Rio!
(photo: exfordy via flickr)
But today, many more nations enjoy political stability and a friendly business climate. The American Dream has gone global and English is the most widely spoken language of business all around the world. As a result, states and nations may find that they now have to compete to gain and to keep the people who are susceptible of creating the most wealth and the most tax revenue. In an age of diminished demographics in developed countries, keeping the most productive wealth creators gains crucial economic significance. If taxes rise too much in a state or country, many people will move to another state or country. Depardieu went through Belgium (maximum income tax rate 50%) but eventually landed in Russia (maximum rate 13%) for at least long enough to pick up his new citizenship and passport personally delivered by President Putin.
If Belgium’s rate of 50% seems too high and if Russia is too cold or remote, consider the highest tax rates in the following countries: Hong Kong 15%, Brazil 27.5%, Liechtenstein 17.8%, Singapore 20%, Switzerland 22.4% (lowest tax canton). Some smaller countries like Bermuda, the Cayman Islands and the United Arab Emirates (including Dubai) have no income tax at all. It would be difficult to forego California but perhaps less so if one’s destination is a resurgent Rio de Janeiro. Singapore, one of the most proactive states in addressing its low birth rate, recently released a report which analyzed the impact of increasing annual immigration by anywhere from 15,000 to 25,000 newcomers. We can expect that it will try to attract some of the most productive people from around the world.
In the United States, the tax competition among states is likely to intensify. Recently, the Governors of Nebraska and Louisiana have expressed their desire to end their states’ individual income taxes. High tax states such as California, New Jersey and New York are seeing a steady outmigration of people leaving towards other states, a population decline which is somewhat mitigated by immigration from other countries.
The world has been turned upside down in more ways than one. It is the countries of the free world, the USA and Western Europe, which are comparatively less free when it comes to taxation and regulation, while the former communist countries have adopted some of the lowest tax rates and least burdensome regulations. This divide is visible in Europe where Western Europe is in recession but Poland and Latvia are doing quite well.
Lost Labor Mobility
And labor mobility which was historically one of the United States’ greatest economic strengths is in theory now easier in many (most?) other countries where people can divorce themselves from one tax jurisdiction and adopt another simply by moving from one country to another. By contrast, the US taxes its citizens and residents (green card holders) at the federal level on their worldwide income whether they live in the US or abroad (some limited exemptions are allowed). This may succeed in keeping many would-be migrant tax evaders within the United States, but it also deters at least some skilled and productive foreigners from coming here and encourages them to head for lower tax destinations. A few decades ago, an actor leaving France would likely have chosen New York or Los Angeles, but now it seems that neither was considered desirable by Depardieu.
There is certainly an important economic cost associated with a decline in labor mobility. Mobility can act as a useful mechanism to impose discipline on a government’s finances and policies.
Lowest Tax and Lowest Cost
Exhibit Two of l’Affaire Depardieu is the fact that wealth itself is more mobile. A large share of wealth in the United States today is derived from intellectual property which is more portable than wealth gained from hard assets. When people created wealth from large and expensive hard assets, such as mines, railroads or factories, as they did in the 1950s-60s, most of their assets stayed behind if they decided to move away. But when people now create wealth primarily from intellectual property assets (brands, copyrights, patents etc.), their main assets move with them wherever they go.
This is certainly the case with an established actor like Depardieu whose revenue stream follows him wherever he goes. But it is also increasingly true of newer corporations. If an older company like Ford moves to Singapore, many of its factories will stay in the US. But if Google or Facebook move to Switzerland, the bulk of their revenue generating assets will move with them, as will their liabilities to a new tax authority. Today, owners of brands and patents can create enormous wealth with small teams located in low tax countries and outsource production and other tasks to other, low cost, countries.
And here lies the ultimate lesson: In the age of globalization and of dominant intellectual wealth, many innovators will locate in the lowest tax states and their manufacturing will locate in the lowest cost regions of the world, in both cases bypassing the high-tax high-cost demography-challenged countries of the West.
The main reason some businesses will seek to lower their taxes and costs will be to remain competitive. A company based in a higher-tax jurisdiction may find it more difficult to compete with say a Singapore-based company which pays lower taxes and therefore has greater cash flows to invest in its own business.
Taxing Goodwill
As an aside, note that companies with large intellectual property portfolios (software, healthcare, media etc.) are valued in the market at significantly higher multiples of their book values than old line companies in for example the automobile, mining or steel industries. That differential between book value and market value is mainly goodwill: brands, patents, copyrights etc. This poses another challenge to the tax man. How do you ‘spread the wealth’ when wealth is wealth only for as long as it remains in the hands of its creators? One way to do it is by raising taxes on the incomes of the patent owners. But they in turn could defer or minimize their annual incomes (by minimizing salaries and dividends) to lower their tax bill, largely offsetting the tax revenues expected from the increase in their marginal tax rate.
At the top of the table is a sample group of companies which derive a large share of their value from intellectual property assets. At bottom is a group of more traditional companies which may also have such assets but to a much lesser degree than the first group. The high and low price to book value ratios reflect the high value-added content in the first group and the more commoditized activity of the second group. Shown ratios are as of January 24, 2013.
| P/BV | |||
| Estee Lauder | EL | Branded consumer | 8.8 |
| Starbucks | SBUX | Food retail | 8.0 |
| Intuitive Surgical | ISRG | Healthcare | 6.9 |
| Intuit | INTU | Technology | 6.8 |
| Celgene | CELG | Healthcare | 6.6 |
| Biogen Idec | BIIB | Healthcare | 5.2 |
| Coke | KO | Branded consumer | 5.0 |
| T. Rowe Price | TROW | Asset Management | 4.6 |
| Apple | AAPL | Technology | 3.6 |
| GOOG | Technology | 3.6 | |
| Ford | F | Automobile | 2.9 |
| CSX | CSX | Railroad | 2.5 |
| Dow Chemical | DOW | Chemicals | 1.9 |
| Freeport McMoran | FCX | Mining | 1.9 |
| Newmont | NEM | Mining | 1.6 |
| ConocoPhilips | COP | Energy | 1.5 |
| Wells Fargo | WFC | Bank | 1.3 |
| Valero | VLO | Refining | 1.2 |
| GM | GM | Automobile | 1.0 |
| Allstate | ALL | Insurance | 0.9 |
New Networks
If people and wealth have become more mobile, one should not downplay the importance of networks. Google will likely remain in Northern California and Goldman Sachs in New York City because they derive large benefits from nearby parallel networks of like-minded professionals. But at some point, these benefits may be outweighed by the differential between a firm’s current tax bill and its future lower tax bill at a new location. In addition, a new network can take root in a new location, anchored by a large firm or by a university, as witnessed by the technology industry’s fast growth around Austin.
New York City is hoping to seed its own engineering and technology hub networked around Cornell University’s proposed campus on Roosevelt Island. But it is taking a big chance with its high taxes and byzantine rent stabilization laws. Add to this the fact that New York State demographics are even worse than those of the US as a whole (see for example the map in this article) and it is no longer a stretch to say that New York City and State are not necessarily configured for future prosperity. Silicon Valley grew around Stanford mainly in an organic fashion and it remains to be seen whether its success can be duplicated by design, with a top down approach, in one of the highest-tax highest-cost parts of the country.
As to other sectors, low tax locations such as Texas and Florida lack the professional networks of New York City in finance and media. But this does not have to be true forever. For example, many Wall Street professionals already have ties to Southern Florida and the ‘Wall Street in Florida’ network will continue to flourish, in particular if Europe continues to stagnate and Latin America to grow.
Again this is no longer 1950 or 1960 when the US and its main hubs had a quasi monopoly on prosperity and the good life. There are other, more welcoming, less expensive destinations for smart ambitious young men and women born and raised anywhere in the world. A top engineer from say India does not have to come to America to make it big. He can go to a number of other countries or indeed stay home. Because of its large population and declining fertility rate, India’s economy could reap a significant demographic dividend in the decades ahead.
Two of the main pillars of economic growth have been innovation and demographics. Innovation is the key to wealth creation but innovation requires a large target demographic in order to realize its full economic potential. We made the case previously that the demographics of the United States are deteriorating and should no longer be seen as a robust engine of growth. But export markets can continue to grow and innovation can continue to benefit the American economy, that is unless innovators decide to settle in Hong Kong, Singapore or Switzerland instead of California, Texas or New York.
