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TAX NEWS - may 2010

The Growing Tax Threats to Your Investment Portfolio

by Dr. Mark Skousen
"To prohibit a great people… from making all they can of every part of their own produce, or from employing their stock and industry in the way that they judge most advantageous to themselves, is a manifest violation of the most sacred rights of mankind. Little else is required to carry a state to the highest degree of opulence but peace, easy taxes and a tolerable administration of justice."
- Adam Smith, The Wealth of Nations (1776)

Famous last words. Today with Wall Street and the global markets tagged as greedy speculators who triggered the financial crisis, institutions and investors in the United States and abroad are facing a slew of new taxes and regulations.

For example...

- Transaction Tax on Buying/Selling Financial Instruments: Both the U.S. Congress and European legislatures are considering imposing a new transaction tax on investments. Democratic Congressmen Peter DeFazio (Oregon) and Ed Perlmutter (Colorado) have introduced a bill entitled, "Let Wall Street Pay for the Restoration of Main Street Act." Under it, the purchase and sale of stocks, options, derivatives and futures would face a 0.25% tax.

While the amount seems small, it's expected to raise $150 billion. However, Princeton economist Burt Malkiel and other experts say it would reduce New York trading volume by 30% or more and could significantly increase the bid-ask spread on stocks.

- Raising Taxes on Stocks: Both America and Europe also want to raise taxes on investment gains. President Obama wants to raise the tax on dividends and long-term capital gains to 23.8% (20% plus the 3.8% tax to pay for the healthcare bill). For the past eight years, this investment tax has been 15%, one of the few tax breaks for conservative investors and retirees. But that will disappear in 2011.

In Europe, German officials recently agreed to work toward a financial tax that would hit stock trades or the profits, salaries and bonuses of financial institutions. This levy would suck up to 1.2 billion euros ($1.5 billion) a year out of the financial industry.

- Outlawing Short Selling: Last week, German regulators adopted the same strategy as Congress in 2008 by banning short-selling. It included bans on the short-sale of certain Eurozone government bonds and credit-default swaps, plus on shares of the 10 largest German banks.

But Europe would do well to remember the effect that these anti-business measures had in the United States. Wall Street shares sold off sharply, taking the global markets down, too. Governments are often the last to recognize the law of unintended consequences.

In short, one of the greatest threats to economic growth is taxation - specifically, taxes on savings, dividends, interest income, capital gains and estates. But how?

The Government Goes on the Attack... Against Itself

Simply put, these taxes ultimately destroy the investment funds for capital formation - and inevitably lead to lower economic growth.

With regard to the taxes on investors and Wall Street, legislators fail to realize that taxing dividends and interest isn't simply a tax on the rich, who can afford to pay them… but an attack on capital formation and economic growth.

For example, an estate or inheritance tax isn't so much a "death" tax as it is a destruction of investment capital. The money that is taken from a savings or investment account and sent to Uncle Sam is wasted capital that will never return.

In 1920, John Maynard Keynes warned that, "The virtue of the cake [savings] was that it was never to be consumed, neither by you nor by your children after you."

But that's precisely what taxation does. It consumes the savings/investment cake - the source of future wealth.

Lessons From Britain and China

Yet it seems the government is hell-bent on finding every means possible to tax these sources of wealth creation - all in the name of taxing the wealthy and those greedy speculators.

However, the laws of economics are iron-clad: A tax, albeit small, will increase bid-asked spreads, reduce volume and increase volatility. By how much? Britain provides some answers…

For many decades, Britain has imposed a 0.5% "stamp duty" on trades on the London Stock Exchange (LSE). However, the tax has slowed the growth of the LSE. In fact, Euronext, the European Union exchange based in London, recently surpassed the LSE in market capitalization due to its electronic efficiency.

Over in China, three economists examined the impact of a stamp tax increase from 0.3% to 0.5%. They found that trading volume declined by one-third, market volatility increased significantly and the markets became less efficient.

So where does that leave the United States?

The Next Tax to Hit America… And Where You Can Go to Avoid the "Tax Rush"

According to a Brookings Institution study, a stock tax will cost investors at least $138 billion in lost stock value alone.

In addition, my colleague, Alexander Green, notes another potential tax: "The real killer, which (in response to the out-of-control budget deficit) will be recommended by a bi-partisan panel after this year's election is a VAT (Value Added Tax). This will hit retirees especially hard."

So where can you go to dodge this tax torment and see how Adam Smith's vision of "easy taxes" has been adopted?

Look to Hong Kong. It has no tax on dividends, capital gains, stock transactions, or estates, plus a relatively low flat tax on business and personal income. In fact, Heritage Foundation rates it as one of the fastest-growing places in the world, with the freest economy in the world.

Good trading - AEIOU,

Mark Skousen
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