Government Tax Rates Create Moneymaking Opportunity

Economics works!

That is if you consider that economics is the study of incentives.

I have been writing over the past two weeks about the current phenomenon called "inversion."

The subject of inversion has to do with American tax rates on corporations, which are among the highest in the developed world, and the movement of United States firms to buy companies in another country and then move their headquarters out of the United States into the home of the acquired firm.

[Read: Hedge Funds Hate These 5 Stocks – Should You?]

The incentives for doing this -- the high corporate tax rates -- make it difficult for the American firms to be competitive in a world market. Thus, by moving its headquarters to another country with a lower corporate tax rate, the company returns to a more competitive position in the marketplace.

But, there is another incentive. "Hedge funds are wagering billions of dollars on companies they believe will benefit from a wave of takeover deals designed to lower taxes for U.S. acquirers." This is from The Wall Street Journal.

This is the whole essence of macro-trading efforts. In many cases, the government creates a situation that establishes incentives for people to make lots and lots of money. The government does not plan to do this. In fact, the exact opposite is usually the case. The government sets out to do something good -- and then finds out the incentives that have been created do pretty much the opposite of what they had hoped.

This type of situation, of course, is in the realm of "unintended consequences."

And, this happens over and over again.

The most popular blog post I have ever written is titled "Bernanke Is Underwriting the Wealthy." In it, I discuss how the low interest rates that were created by Federal Reserve policy opened opportunities (incentives) for people to take positions in assets and reap substantial gains.

This brings up another point, however: the fact that many, if not most, of these opportunities can only be taken advantage of if you have a lot of money, are sophisticated financially or if you have access to the advice and vehicles needed to make investments in these areas.

It can also be said that a lot of government policies aimed at helping the "middle class" or the "poor" or the "disadvantaged," although they may start out by helping those the programs are intended for, end up actually making them relatively worse off.

The classic case taught in economics courses is that of rent controls. The aim of rent controls is to keep rent levels relatively low, so that the middle classes or lower middle classes can afford to continue living in their rental units. The incentive for landlords is to somehow find a way to continue to earn a competitive rate of return on their rental units while keeping rents at the controlled level.

The overwhelming response to this situation is for the landlord to cease to maintain the rental units. Thus, the rents remain the same, but the quality of the rental units decline.

[Read: Inflation Pressures Abate, at Least for Now]

Over the last 50 years or so, a lot of individuals in the investment community have gotten very good at finding ways to take advantage of government policies. For example, in the early 1960s, the federal government began a policy of credit inflation based upon a foundation of deficit spending. This policy was aimed at keeping the labor force as fully employed as possible.

The problem is this credit inflation ended up producing consumer price inflation, which in the early 1970s got people moving into gold and other assets that would appreciate in price in the face of the excess demand going around. The credit inflation was continued, and it was found that asset price inflation, such as the rising price of houses, underwrote the wealth of a lot of people going into the 1980s and 1990s. This credit inflation also resulted in an incredible amount of innovation in financial instruments in the 1990s and 2000s.

Many investors have become very sophisticated in identifying opportunities to make large amounts of money created by government programs and policies. And, with the evolution of hedge funds, private equity funds and asset management groups, there are individuals who are trained and ready with the money to move into these situations arising out of the incentives produced by the government.

Going forward, governments will have to think more and more about not just the good that might be done through specific programs and policies, but the unintended consequences of those programs and policies.

Maybe the government needs to take a look at itself in the mirror when it starts discussing all the income/wealth inequality that has been created over the past 50 years.

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