Letter from America
By Charles Sizemore, CFA
Chief Investment Officer, Sizemore Capital Management LLC
We ask the question above tongue-in-cheek, of course. Despite the occasional bout of populism, the United States remains an open economy and has, with relatively few (but notable) exceptions, held fast to the Anglo-Saxon tradition of the rule of law. While we respect the enthusiasm for low taxes and limited government exhibited by the attendees of the various “Tea Parties” that erupted across the country on April 16—the day that Americans are required to file their federal tax returns—we would like to reiterate that things are not quite as bad as they might seem. That said, the demonstrators do raise several valid points, and we believe that many of their criticisms are warranted.
This month, we are going to take a hard look at the condition of economic freedom in the United States and analyse the significance of recent developments.
State of the Union, 2009
Passions are running high on this side of the Pond. There is an increasingly widespread belief that the collapse of the financial system in 2008 was the result of systemic moral hazard in which risk had become divorced from return, and in which decision makers faced no real consequences for their actions. Large banks and corporations deemed “too big to fail” could enjoy the benefits of a high-risk, highly-geared strategy when that strategy was successful. But if it failed, the government would be there to bail them out. Hence, a “heads I win; tails you lose” mentality began to pervade the economic system.
Likewise, individual Americans became increasingly risk tolerant and, it must be said, lacking in good judgment regarding their finances. The savings rate actually turned negative during the mid-2000s. Home equity was “extracted” and used for current consumption. Purchases that would have been considered frivolous in prior decades—such as a $5 coffee delivered via a Starbucks drive-through window—suddenly became “necessities.”
But perhaps the greatest moral failings belong to the US Federal Government. Former President George W. Bush was arguably the most fiscally irresponsible president since the last Texan to hold the office, Lyndon Baines Johnson. (Being born and raised in Texas ourselves, it always pains us a little to say that. Texans, due to their past experiences living under dictatorship, have always preferred weak executives in the state governor’s mansion. If we don’t trust our own politicians to wield power responsibly at the state level, it’s difficult to imagine them being suitable at the national level).
Under President Bush, federal budgeted expenditures rose by well over 50%. Worse, future generations will have to pay for the almost unfathomably large liability added to the national balance sheet in the form of Medicare Part D, the state-funded prescription drug benefit for seniors.
Sadly, it gets worse. As we have mentioned in prior months, in a case of true Orwellian doublespeak President Barack Obama proposed the largest and most bloated federal budget in the history of the Republic—at $3.5 trillion—and had the audacity to call it a “New Era of Responsibility.” It is difficult for us to understand how incurring massive debts to fund current spending is “responsible,” or even “new” for that matter.
In his first 100 days in office the new president, like his predecessor, has become a rather polarising figure. Small-government activists complain that some of his actions have eroded the rule of law and property rights—the very foundations of capitalism itself. These criticisms are worrisome, to say the least, and not completely unfounded.
What happened to the rule of law?
Americans of all political stripes justifiably take pride in their legal system and in the privacy provisions enshrined in the country’s constitution—particularly the Fourth Amendment prohibition against unjustified searches and seizures. But much to the dismay of civil libertarians, recent changes in the law have weakened these constitutional protections. In the climate of fear following the September 11, 2001 terror attacks Congress passed the USA Patriot Act of 2001. In addition to loosening the standards for controversial “sneak and peak” warrants and “roving” wiretaps, the Patriot Act expanded certain provisions of the Bank Secrecy Act of 1970.
The Bank Secrecy Act is perhaps one of the most poorly named pieces of legislation in US history. Rather than protect the banking privacy of law-abiding citizens, the Act actually requires banks to spy on their customers and report suspicious activity to the IRS. (“Suspicious activity” includes any cash transaction of $10,000 or more, among other criteria.)
The Patriot Act and Bank Secrecy Act have made life more difficult for would-be terrorists, money launderers, and tax cheats. But they have done so at the expense of subjecting law-abiding Americans to a level of surveillance and scrutiny that would have appalled past generations, and both are of questionable constitutionality.
President Obama cannot be blamed for acts that preceded him, of course. But during his short presidency he has certainly contributed his own controversies, not least of which are the White House plans for the reorganization of Chrysler and General Motors. Running roughshod over the legal rights of creditors, the President has effectively said that the priority of liens does not matter.
In the case of Chrysler, the creditor banks—who have first lien—would have only recovered 29% of their investment under the reorganisation, while the United Auto Workers union—whose claim is unsecured—would have recovered 43% of the money owed them. The UAW would have also taken a 55% ownership interest in the company, and the US Government would have taken another 8%. Government and labour jointly owning a major American corporation? Come to think of it, that does sound a bit like a people’s republic. Not surprisingly, the creditors rejected the plan and opted instead for bankruptcy court.
President Obama’s actions have set a horrible precedent. Contract law and creditor protections are the building blocks of the capitalist system. It is faith in the rule of law that allows the American government and American companies to enjoy low interest rates. But what happens when that confidence is shaken? Might capital become scarcer, causing interest rates to rise? Money moves where it is treated best, and at present it is being treated with outright hostility in the United States. But again, the story gets even worse.
American expatriates can leave, but their assets stay
Most of the readers of this publication are likely already aware that the United States is the only country in the world that taxes its non-resident citizens on their income earned abroad. For example, an American living full time in Europe, earning a salary from a European company, is required to report and pay taxes on that income in the United States.
Of course, governments have a right to levy taxes in return for the services they provide, such as police and military protection, the legal system, and the regulation of labour and business. But when an American lives and works abroad, it is difficult to understand why he or she owes taxes to a country in which they do not reside. Alas, there is no “lobby” for Americans living abroad to influence tax policy, and with the government running record deficits expatriates make easy targets. As unfair as it is, we expect no change in the tax laws to benefit American expatriates in the foreseeable future.
If anything, recent experience suggests the situation could get worse. In 2008, President Bush signed the Heroes Earnings Assistance and Tax Relief Act, a seemingly harmless bill designed to offer financial assistance to military families. Unfortunately, it is a potential nightmare for American expatriates.
The law essentially prevents wealthy Americans from leaving the country as “tax exiles.” More accurately, it prevents them from leaving with their wealth. According to accounting firm Deloitte Touche, any American citizen or permanent resident wishing to expatriate with a net worth of $2 million or an average annual tax liability of $139,000 must pay an exit tax of 30% on the “mark to market” value of all gains in asset values in excess of $600,000.
In addition to going against the American tradition of economic freedom, this law is counterproductive and damaging to the long-term interest of the United States. Given the country’s chronic budget and current account deficits, America needs foreign capital. But in an age where capital is highly mobile, why would any would-be entrepreneur want to build a business in America knowing that they cannot take their profits with them should they decide to leave? Why not simply start that business elsewhere?
In the long run, the attitude of the U.S. government towards expatriate taxation will erode the country’s competitiveness and will drive vitally needed investment dollars to foreign shores.
In the title, we asked if the American Republic was becoming a people’s republic, a communist country. The answer, of course, is no. President Obama’s proposed $3.5 trillion budget, if implemented, would mean an enormous expansion of federal power. But does it really compare to Roosevelt’s New Deal or Johnson’s Great Society programmes? Absolutely not.
The country’s apparent surge to the left has to be viewed in context. The current Administration and Congress are to the left of recent Presidents George W. Bush and Bill Clinton. But it should be remembered that the political centre of gravity has shifted massively to the right over the past three decades. Mr. Obama’s lean to the left is part of the natural ebb and flow of the political process.
Furthermore, the constitutional system of checks and balances is still working. At varying times over the past 100 days, the President and the Senate have used their influence to moderate the passions of the House of Representatives, with the AIG bonus scandal being perhaps the highest-profile example. At the same time, both houses of Congress have acted as a brake on Mr. Obama’s rather ambitious domestic agenda.
The individual states are also reasserting themselves at a level not seen in forty years or more. Numerous states—including our native Texas—have publicly “reaffirmed” their commitment to the 10th Amendment of the Constitution. This is a polite way of reminding the federal government that the American system is one of shared, competing sovereignty between the state capitals and Washington D.C.
These developments give us hope. The American constitution was written with the express intention of frustrating excessive political ambition. Though a lot of bad laws still manage to get passed, the system is largely doing its job of forcing the government away from ideological extremes and toward the centre.
This does not mean, however, that American expatriates have nothing to worry about. Given the extreme populist sentiments against “the rich” and the revulsion towards the financial services industry in general, expatriates have no real advocate. As a small and comparatively wealthy group, they make an easy target for a cash-starved government. For the time being, expatriates should be very aware that they are in the government’s crosshairs.