For several decades, there has been a gradual but significant shift in U.S. tax policy that favored strong stock performance on one hand, and the offshoring of many U.S. jobs on the other.
Here is a chart that captures it well:
Data Sources: U.S. Bureau for Economic Analysis, U.S. Treasury, Tax Policy Center
This article examines that shift, how it has impacted investor portfolios, and why it may change in the future.
I’ll start by quantifying a few of these changes, and then I’ll move into discussing some of their likely ramifications and potentials for reversal.
A Shift from Corporate Taxes to Payroll Taxes
For several decades, there has been a consistent decline in the effective federal corporate tax rate in the United States from over 40% to under 10%. While there’s no perfect way to measure it, here are two versions of it:
Chart Source: St. Louis Fed
The headline tax rate for corporations has decreased over time, but the effective tax rate in practice is a different (and lower) number, as shown in the chart above. There are a variety of tax details that change over time, in addition to occasional changes in the headline number, and they generally have resulted in lower and lower percentages for corporations to pay out of their income.
The blue line in the chart above estimates total corporate tax rates, and is calculated as follows:
The red line in that chart isolates the federal portion of those taxes, and is calculated as follows:
The effective tax rate tends to dip during recessions, but besides that natural cyclical element, there has been a consistent structural decline.
On the other hand, there has been a steady rise in payroll tax rates, although this did level off in recent decades:
Data Source: Tax Policy Center
This currently includes a 12.4% social security tax and a 2.9% Medicare hospital insurance tax, totaling 15.3%.
The social security tax is capped, and thus only applies to the first $137,000 or so of income (which goes up slightly each year to account for inflation). However, the 2.9% Medicare hospital insurance tax portion is not capped, and applies to the full amount of earnings. In addition, there is a 0.9% Medicare extra tax that kicks in for earnings above $200,000 which is not included in the chart above.
Half of the payroll rate is paid by employees, and half is paid by employers on their behalf. Therefore, the employer half of payroll taxes can be thought of as another type of corporate tax. Self-employed people pay both halves themselves.
The net result of this structural shift is that payroll taxes have increased substantially as a percentage of federal revenue, while corporate taxes and excise taxes have significantly diminished:
Chart Source: Tax Policy Center
So, over time, we’ve taxed corporations less at the point of profit, and more at the point of employment, which is an interesting policy choice.
This is true to a certain extent for many other countries as well; the United States is not unique in this trend. However, the U.S. accelerated this trend more than most other countries over the past decade, and the next factor is a mostly American phenomenon.
The Extra Healthcare Layer
In addition to paying higher payroll taxes, employees and their employers in the United States pay the highest annual per-capita healthcare costs in the world. We’re up to over $11,000 per person while most countries (including advanced countries with longer average lifespans, older average population ages, and lower infant mortality rates) are under $6,000:
Chart Source: OECD
In particular, U.S. healthcare costs have risen much faster than the base inflation rate since the mid-1980’s, as calculated by the U.S. Bureau for Labor Statistics:
Chart Source: St. Louis Fed
The reasons for this are complex and outside of the scope of this article, so for our purposes here, we just care about the “how much” rather than the “why”.
For career professionals, healthcare coverage is often obtained through their employers. Employers typically pay the bulk of the cost, with employees picking up the rest. The employer’s share of the employee’s healthcare cost is part of an employee’s compensation package, and any smart prospective employee with competing employment offers will consider the base pay plus the variety of benefits from each potential employer, with healthcare coverage generally being the most expensive benefit.
So, high employee healthcare costs are a burden for companies operating in the United States, and specifically for companies hiring workers in the United States, not to mention being a burden for employees themselves.
When employers offer healthcare as part of their compensation package, we can think of this as basically another payroll tax, and unlike the actual payroll tax, this one has skyrocketed over the past 30 years rather than leveling out.
Note that both of these tax and healthcare cost trends shown above are structural over decades. If I were to remove the dates from the charts, it would be difficult to tell for any particular period which political party is running the country at that moment.
Ramifications: Stock Appreciation & Labor Offshoring
In a number of articles and podcast discussions, I have often discussed how, several decades into the current period with the United States’ dollar as the global reserve currency, the country is now increasingly on the wrong side of the Triffin dilemma. For more information about that topic in particular, see my article on it.
The Triffin dilemma is based on economist Robert Triffin’s analysis of what happens if a country has the global reserve currency; they have to supply plenty of currency units to the rest of the world for it to be used as the global reserve currency, and that takes the form of running persistent trade deficits. Triffin warned about this back in the 1960’s, and things have played out like he expected.
A country with dominant economic and geopolitical power can set up a global reserve currency by design, and then it becomes partially self-perpetuating. In order for the currency to be widely used, the global reserve currency needs to be in global abundance outside of its home country, so the country needs to be large and needs to run frequent trade deficits (i.e. the world can’t use Swiss Francs as the global reserve currency; there aren’t many around). From that point, once established, there tends to be persistent global demand for the global reserve currency (due to the currency’s broad acceptance and because foreign companies and governments often start building up debts based in that currency and need that currency to service those debts), which makes it overvalued and thus gives the world reserve country more importing power but also less export competitiveness. This inherent currency overvaluation leads to that country running persistent trade deficits, which gets those currency units out into the world and keeps the cycle going.
In the post Bretton Woods era, meaning most of the past five decades since the dollar went off the gold standard, the dollar as the global reserve currency has primarily revolved around commodity pricing. Oil and most commodities are priced predominantly in dollars around the world, which helps create plenty of supply and demand for dollars around the world. This is a specific geopolitical choice by the U.S. that they maintain over time where possible.
In exchange for having extra military dominance, the relatively unique ability to print its own currency to buy commodities and other imports, and decades of consuming more than it produces (these benefits are collectively the “exorbitant privilege” part of the deal), the country with the global reserve currency basically has to hollow out its manufacturing base and send those supply chains overseas, because they need to run trade deficits and their high-value currency generally makes many of their physical exports uncompetitive (which are the unmentioned “exorbitant burden” parts of the deal).
This works reasonably well for decades as the benefits initially outweigh the burdens, but eventually it leads to a very polarized society and a deeply negative net international investment position, and these things in turn start to threaten the country’s ability to maintain global reserve currency status. And by that point, the burdens for having that status may outweigh the benefits anyway.
The reason I bring the Triffin dilemma up, is because decades of the aforementioned tax policy and high healthcare costs have likely exacerbated the Triffin dilemma.
In fact, if I were to design tax and healthcare policy specifically with the goal of offshoring labor, doubling-down on incentivizing businesses with low headcounts, and maintaining a structural trade deficit, this approach that we’ve been doing in the United States for decades is pretty much what I’d go with: tax companies more at the point of employment and less at the point of profit, while also having the highest per-capita healthcare costs in the world.
From Creditor Nation to Debtor Nation
The net international investment position of a country, or NIIP for short, measures how much foreign assets (stocks, bonds, and real estate) they own minus how many of their assets foreigners own. A positive NIIP means that the country owns more foreign assets than foreigners own of their assets. A negative figure of course means that foreigners own more of their assets than they own of foreign assets.
Countries that run persistent current account surpluses tend to build up positive NIIPs, as they collect currency from around the world and reinvest it into owning foreign assets. while countries that run persistent current account deficits tend to decline into negative NIIPs.
Here is the chart of the U.S. net international investment position over time:
Chart Source: St. Louis Fed
After the two world wars in the first half of the 20th century, the United States was the most positive country in the world by this metric; Americans owned more foreign assets than foreigners owned of American assets.
However, due to decades of persistent trade deficits from there, this gradually decreased over time. By 1985 we went mildly negative and remained there for about twenty years, and then in the past 10-15 years we really took a nosedive on this metric, as the chart above shows.
Meanwhile, countries like Germany and Japan have built up the largest positive net international investment positions in absolute terms instead, and some of the highest on a percent-of-GDP basis as well.
Here’s how the U.S. net international investment position as a percentage of GDP compares to the rest of the world, as of the end of 2019:
Data Source: IMF
According to the U.S. Bureau for Economic Analysis, the United States collectively owns about $27 trillion in foreign assets, while foreigners own about $39 trillion in U.S. assets. This creates a -$12 trillion net international investment position, or worse than -50% of GDP.
Wealth Concentration
Here is the share of wealth owned by the top 1% in major developed countries, plus China as a developing country, as of 2019:
Chart Source: Credit Suisse 2019 Global Wealth Report
Here is the mean and median wealth for several top nations:
Data Source: Credit Suisse 2019 Global Wealth Report
We mostly have to look into emerging markets or small city-states to find countries that have more wealth concentration than the United States has. Among large developed nations, we’re right near the top.
Some people make the case that average country age primarily determines wealth inequality; older populations could have less wealth inequality, while young populations can have more, as the hypothesis goes. That’s true to some extent by development; emerging markets are usually younger and also more unequal; as a country becomes developed, it usually has an older population and less extreme inequality.
However, the age and wealth trend doesn’t hold very well when comparing developed nations. The oldest European country on that chart is Germany, which is near the top of the wealth inequality list. The United States is on average just 4 years younger than the European Union, and that 4-year age gap doesn’t explain the 6x mean-vs-median ratio of the United States compared to a sub-3x mean-vs-median ratio that most other countries on the list have. Australia and the United States have about the same average age, and yet are on total opposite sides of the mean-vs-median ratio in the chart.
Many analysts argue that quantitative easing or “QE” programs (creating bank reserves to buy financial assets) by central banks around the world exacerbates wealth inequality, by propping up asset prices predominantly for the top few percent of people that own them. While this is true to a degree, the charts above reveal an interesting fact: countries that did the most QE as a percentage of GDP have the least wealth inequality.
Japan is the world leader for quantitative easing both in terms of how early they adopted it and the scale to which they’ve done it. They have been doing it for two decades, and their central bank balance sheet now owns assets that equal more than 100% of the country’s GDP.
This chart shows central bank balance sheets as a percentage of GDP for major currency areas, which is a rough measure of how much cumulative quantitative easing they’ve each done. Japan is soaring far and above the others with the green line:
Chart Source: Yardeni
And yet, despite Japan being head and shoulders above the others in terms of QE, as the Credit Suisse chart shows above, Japan has among the lowest levels of wealth concentration in the world, and the top 1% in Japan have a smaller share of the wealth than they had two decades ago when all of that epic QE began. This goes somewhat against the narrative that quantitative easing, in principle, exacerbates wealth inequality as a dominant variable.
Next up, the European Central Bank has been a big fan of QE as well, especially after the European sovereign debt crisis early this past decade. Although they haven’t done as much as Japan, they’ve done more quantitative easing than the United States as a percentage of GDP. The blue line for ECB’s balance sheet in the chart above doesn’t take into account Q2 yet, but the Fed’s red line does, so the blue line will go up in the coming weeks when we get a data update). And Europe’s level of wealth concentration happens to be roughly between that of Japan and the United States.
So, we actually have somewhat of an inverse correlation here: more QE = less wealth concentration? Clearly there have to be other variables then, including more powerful variables, that influence wealth concentration within a given country. QE on its own cannot be the key driver of it since we can’t even establish a positive correlation here. I’m not making the case that QE reduces inequality; I’m merely saying that it’s not far and away the key variable that exacerbates it, as many believe it to be.
And that’s why I’ve focused my research quite heavily on the dollar’s global reserve status, and various policies in the United States, because these are some of the stronger forces influencing these trends. It’s always easier if we can find one variable or one thing that we can identify as the cause of something (i.e. as if we can lay the problem of wealth inequality entirely at the feet of the Federal Reserve’s monetary policy, as many do), but the way it works in reality is that multiple variables are involved, and this situation is no different.
A combination of fiscal and geopolitical policies and other factors outweigh monetary policies when it comes to wealth concentration, according to the evidence.
Industry Winners
By shifting the tax focus from the corporate level to the payroll level, these changes in tax policy have naturally affected some industries more than others in the United States especially, and in other countries to some extent.
If corporate taxes on profit are going way down, but the per-employee cost of hiring Americans is going way up due to payroll taxes and employee healthcare costs, then what sort of businesses will flourish in that environment?
The answer is businesses that make a lot of money without being very labor intensive, such as software companies and investment banks. These companies earn a ton of revenue and income per employee, so the payroll tax and healthcare costs are manageable, while they reap the benefits of lower and lower corporate tax rates.
It’s perhaps not surprising that the most successful companies in the stock market over the past decade were very low in terms of labor intensity:
Chart Source: A Wealth of Common Sense
On the other hand, labor-intensive businesses, such as manufacturers and retailers, don’t tend to do as well in this environment unless they adopt some counter-strategies to deal with these policies.
For manufacturers, the obvious strategy is to outsource where possible. Make your T-shirts in Bangladesh, assemble your phones in China, build your car parts in Mexico, and put part of your IT department in India. Or, use robots where possible, especially since they keep getting better. And then keep your corporate offices and consumer distribution points here in the United States.
It’s not surprising, then, that the United States has among the lowest contribution to GDP from the industrial sector out of major countries, at 19%, and among the highest contribution from the services sector, at 80%. Only a few major countries, such as France (which is heavily reliant on tourism) come close to those figures.
It’s not just emerging markets that manufacture things: Germany and Japan and several other peer nations generate about 30% of their GDP from the industrial sector, which is a big difference vs our 19%. The United States is statistically unusual among major countries in terms of how small a share of GDP the industrial sector is.
Specifically, the share of U.S. GDP from manufacturing has gone down more quickly than many of our peers:
Chart Source: St. Louis Fed
A recent article from Nikkei, which was also republished in FT, reported that Japanese automakers are potentially willing to triple their pay for Mexican workers to fulfill new trade policy requirements, rather than move those manufacturing facilities to the United States.
For labor-intensive retail and restaurant businesses, it’s a bit harder, since you can’t outsource in-person blue collar service workers. One option is to automate where possible. Another option is to provide no or light healthcare coverage for workers, and to get government or customer assistance to cover employee costs where possible. Many employees at some of the largest retail corporations in the United States, rely on taxpayer-funded food stamps to cover expenses, and restaurant serving staff are compensated through tips more-so in the United States than elsewhere in the world.
Moreover, retail companies that have not adapted well, are struggling. The “retail apocalypse” is real for most companies that don’t have a unique selling proposition and haven’t adopted well to online distribution. For example, Business Insider reported that more than 6,000 stores are closing in 2020. This retail apocalypse was already happening pre-pandemic, and the pandemic accelerated it by pressuring the remaining marginal cases.
If we look at the trade deficit again, the United States has a large services trade surplus (red line below), and a massive goods trade deficit (blue line below). The goods deficit is larger than the services surplus, so the overall net result is a deficit for goods and services combined.
Chart Source: St. Louis Fed
The goods trade deficit would be much worse today if not for recent shifts in energy pricing and production. The decline in energy prices compared to their 2008 peak levels, as well as increasing oil production within the United States due to shale extraction, reduced some of the goods deficit over the past decade, which masks how deep the goods deficit ex-energy actually is, which is relevant for the manufacturing base.
This, again, fits into the view that tax and healthcare policies have been a powerful positive force for companies with low employee headcounts (software, high-margin tech products, investment banking, and other higher-end service-oriented businesses), while forcing high employee headcount businesses to offshore, automate, or have their employees rely partially on taxpayer assistance, in order to mitigate the impact.
Results Summarized
As the United States outsourced a large portion of its industrial base and doubled down to specialize in less labor intensive industries, it led to strong equity performance, but also increasing wealth concentration and a deepening net international investment position deficit, and thus major winners and losers overall.
While advanced white collar workers have generally done well in this policy environment, many types of blue-collar work have not been very well rewarded in the United States for a while. The median male income, for example, has failed to keep up with big expenses such as rapidly-rising healthcare costs:
Chart Source: Washington Post, Oren Cass
In addition to this blue-to-white collar shift, the United States found itself increasingly symbiotically linked to many other countries, even somewhat adversarial countries. This pandemic, for example, brought to light the fact that we rely heavily on importing masks and pharmaceuticals, because we don’t make much of them here. It has become a national security issue.
On the other hand, these decades have been a very good environment for equity performance.
In particular, from 1990 and onward, payroll tax rates stopped increasing, but effective corporate taxes kept decreasing, meaning the net tax burden on companies went down, especially for companies that are not very labor intensive. That’s fuel for corporate capital compounding. It might be a factor, among several factors, for why S&P 500 valuations broke out of their long-term historical range and remained persistently elevated since about 1990:
Chart Source: multpl.com
The combination of having global reserve currency status and these aforementioned policy decisions that support it (intentionally or not), contributed to the United States being an attractive environment for corporations and highly-paid workers and broad consumption, but a relatively poor environment for blue collar labor, making products, and in general having any sort of labor-intensive business model. It’s been amazing for U.S. asset prices, but not ideal for, say, skilled American craftsmen.
We have, however, seen more fractures of this model start to emerge. I touched on this topic back in 2019 with this article, but the pandemic in 2020 made it more clear to many people.
As one tangible example, the pandemic dis-proportionally hurt the services sector, specifically in the areas of hospitality, transportation, restaurants, entertainment, and similar activities. Meanwhile, the U.S. is highly reliant on the services sector, and doesn’t have as much of a manufacturing base for some of the reasons described in this article.
Here are the official unemployment rates for the United States and the Eurozone over the past twenty years, with the most recent data points in June:
These regions have different unemployment policies and ways of measuring it, and we’ll see how this plays out in time. Employees in the Eurozone are more firmly attached to their employers, whereas in the United States we have more labor flexibility.
However, it is certainly something to watch, as it’s a notable abrupt trend change that could have direct investment implications as well as social/political implications that indirectly affect investment outcomes, if it persists.
Potential Portfolio Impacts
So how does all of this tie into portfolio management?
Mainly, there’s a valid concern from the perspective of an equity investor that most of the juice has been squeezed out of this orange, in a matter of speaking. The pendulum has swung so far in our direction, that it risks stalling and swinging back.
And if that is true, it doesn’t necessarily bode well for real returns of U.S. equity indices going forward into the 2020’s decade.
When effective corporate tax rates go from over 40% to under 10%, it’s hard to go much lower than that, especially when the United States was already running large federal deficits of 5% of GDP prior to the pandemic, and the pandemic blew those deficits out to levels as a percentage of GDP not seen since World War II. So, that multi-decade tailwind of lower and lower corporate tax rates for equities likely doesn’t have much more room to run, and could outright reverse at some point.
In addition, we’ve seen civil unrest, record high reliance on government support, and mega-cap stocks that are not very labor intensive seemingly decouple from the health of the economy and reach a level of concentration in the S&P 500 not seen in over four decades, while more labor intensive companies have generally been more in sync with the rest of the economy, to the downside.
Over the past 30 years, equity markets of many other countries have not been given this significant tax-reduction tailwind, which also means they have less of a potential reversal of that tailwind. Most major countries had smaller government budget deficits as a percentage of GDP than the U.S. in 2019 (and some countries like Germany and Russia had outright government surpluses), and many of them have smaller budget expenditures as a percentage of GDP during this crisis as well.
In other words, one of the reasons that the U.S. was among the best equity markets over the past 30 years, is that it benefited from tax reductions that likely cannot be replicated, and if anything, are more likely to move the other way eventually.
Japanese and European equities outperformed in the 1970’s and 1980’s. U.S. equities in particular, and to some extent emerging market equities, outperformed in the 1990’s. Emerging market equities uniquely outperformed in the 2000’s. U.S. equities uniquely outperformed in the 2010’s.
This chart is a good visual for developed market returns:
Chart Source: A Wealth of Common Sense
And here’s the emerging market vs S&P 500 chart since the emerging market index was created in the late 1980’s:
This chart excludes dividends and dividend reinvestment. If dividends were included in this chart, they would favor emerging markets and the overall returns would be closer.
One reason that I diversify my portfolio geographically and into other asset classes is to minimize single-country equity jurisdictional risk, and thus to reduce the probability of experiencing a “lost decade” as most individual equity markets experience from time to time.
Usually, these decades of shifting outperformance are the result of equity markets reaching valuation extremes, combined with shifts in currency markets and other large trends that change the direction of capital flows.