Wall Street on Paul Ryan: Careful what you wish forAugust 14, 2012: 12:57 PM ET
There are some disturbing consequences for Wall Street associated with Paul Ryan's plan to overhaul the extremely complicated U.S. tax code -- namely, less money for Wall Street.
By Cyrus Sanati
FORTUNE -- Wall Street was giddy last weekend about Mitt Romney's choice of Wisconsin Congressman Paul Ryan to serve as his vice-presidential running mate -- many of the Street's heavy hitters believe the move will boost the Massachusetts Republican's bid to take over the White House. But the glee wasn't reserved to the brokers and traders in New York; it was also seen in the pubs and narrow alleyways of the City of London, Europe's largest financial center, where President Obama is almost uniformly loathed for his perceived "anti-finance" stance.
But the inclusion of Ryan on the ticket could turn out to hurt, not help, the two financial centers and their legions of high-paid professionals. While Ryan is in favor of extending the Bush era tax cuts that the Street likes, he plans to pay for his proposed budget cuts through the establishment of a new tax regime that could have a negative impact on investment.
The U.S. presidential election has become a dominant topic of conversation across the financial world. From Singapore to London to New York, the instant messenger chats that brokers and traders use to communicate with one another are peppered daily with polling results and links to negative articles about President Obama. But this wasn't the case four years ago.
"When Obama was elected, there was a lot of hope - not just by minorities but by Wall Street and invariably the City given the inter-connectedness," one fund manager in the City of London, who wished not to be identified, told Fortune. "We all thought, here's someone who understands the mechanics of finance and won't just use them as the beating horse."
But post-election there was disappointment all around. From Dodd-Frank, the sweeping financial regulatory bill, to the calls for higher tax rates for the wealthy and investors, Obama was seen as an enemy to the financial world. In 2008, employees at Goldman Sachs (GS) gave 75% of their campaign contributions to Democratic candidates, most flowing to the high-profile battle for the White House that pit then-Senator Obama against Republican Senator John McCain, according to data compiled by the Center of Responsive Politics. Fast forward to 2012, and the numbers have nearly flipped, with 70% of Goldman employees giving their campaign donations to Republicans in this critical election year and only 30% going to Democrats.
In London there is a uniform hatred for President Obama as his perceived "populist" policies are thought to be putting pressure on London's financial regulators to crack down harder on the City. There is discussion going on in the UK government to institute a banking split that would go beyond the much-reviled Volcker Rule in the U.S. and actually force banks to totally split off their cash-rich retail arms from their investment banking and trading arms.
But the biggest fear of another four years of Obama centers on taxes. The President wants some of the major parts of the Bush-era tax cuts to end this year. Most notably, Obama wants to raise the capital gains tax from its current 15% to 20% and then raise the tax rate for the highest earners in the U.S. from 35% to 38%. This is not just about the personal pocketbooks of many of the financial players on the Street, although that certainly is a major factor. Rather, it has to do with a possible decrease in investment flows due to the higher capital gains tax rate.
Since the campaign began, Romney's tax and spend plans were cryptic at best – he noted that he wanted to cut the deficit and wouldn't raise taxes, but didn't say specifically how he was going to do it. Enter Paul Ryan, the dashing, young, U.S. House representative from Wisconsin. As head of the House Budget committee, Ryan has had a pulpit to preach fiscal conservatism for nearly two years. His 627-page "blueprint to financial prosperity" has become the Republicans go-to guide on fiscal issues.
For the financial world, Ryan's diametrically opposite viewpoints on everything from healthcare, to regulation and the budget will surely win the hearts of many. His blueprint, which was passed twice in the Republican-controlled House but blocked by the Democratically-controlled Senate, seems to be very business-friendly. Most notable to the investment world is his plan to eliminate all corporate income tax as well as eliminate the tax on interest, capital gains and dividends in order to "promote saving."
The plan is seen as a boon for some on Wall Street, most notably private equity investors, as they would essentially pay no tax on their investment earnings. It is also seen as a positive for the markets, especially the equity markets, as more money would ostensibly flow from people's pockets to Wall Street as opposed to government coffers. In London, it is hoped that this move would push the UK government to act in kind to stem any flow of funds from London to New York, boosting activity in the City as well as on Wall Street.
But to pay for all these tax cuts while also slashing the nation's deficit, the blueprint calls for a major overhaul to the way the government taxes the population. For one, it calls for the slashing of Medicare benefits for the elderly, which would cost the average American to pay an extra $6400 more per year for their healthcare than what would be the case today, according to an analysis of the blueprint by the non-partisan Congressional Budget Office (CBO). That extra cash will need to come from somewhere and it will probably come out retirement accounts, negatively impacting the flow of funds to and from Wall Street.
But there are some even more disturbing unintended consequences for the Street associated with Mr. Ryan's plan to overhaul the extremely complicated U.S. tax code. His plan calls for the establishment of a two-tiered flat tax, where the well-off pay 25% of their income to the government and the less fortunate pay 10%. For this to be possible, the plan calls for the total elimination of tax deductions and tax shelters, save for the normal "standard deduction." If implemented, The Ryan plan would be the biggest change in the U.S. tax code ever.
While this sounds great for top earners who currently pay 35% of their income to the federal government, it isn't all that it's cracked up to be. The complicated tax code has for years allowed the top earners in the country, many of who make their money on Wall Street through bonuses and high salaries, to pay tax rates on their income that were in some instances higher than their secretaries – see billionaire investor Warren Buffett. But he is not alone – it turns out that the top 400 income earners in the U.S. last year had a combined effective tax rate that was well-below 20%. Romney, for example, paid an effective tax rate of just 13.9% last year on his income.
Now, a lot of that comes from paying a lower 15% tax rate on capital gains, something Ryan wants to go to zero, but a significant portion comes from tax breaks on everything from health insurance to charitable contributions, a favorite one for the rich. Both deductions would need to be eliminated for the flat tax plan to work. For example, Romney had around $3 million in charitable tax deductions on his 2010 tax return on an income of $22 million. Around 80% of that money went directly or indirectly to The Church of Latter Day Saints, part of the 10% tithing all Mormons are expected to give each year to the church. If the charitable deduction is eliminated, Romney would still have to tithe to his church, provided he follows church norms, but he won't get a tax break on it, bringing his effective tax rate up.
As a whole, the flat tax seems like a fair and simple way to simplify the tax code. But it also eliminates a myriad of other tax shelters that allow the wealthy to invest their money in funds across the world. The money a wealthy person squirrels away in an offshore account to avoid taxes doesn't just sit there, it is recycled through one of the many money centers around the world and used to lubricate the financial system. If that money has to now flow to the government as a result of Ryan's plan it will mean less money in the financial system for everyone – from Wall Street to London.
For now, Romney says his team will come up with their own plan to fix the budget crisis, but the choice of Ryan is a signal that his team at least agrees with the major tenets of the blueprint, which already has broad-based support among Republican lawmakers as well as with Republican voters. While it is clear that Ryan's pro-investment initiatives is set out to help Wall Street, his tax overhaul plan could cancel out any benefits, in fact, it could actually make things worse. With all the unknowns in Ryan's plan, financial professionals may need to take a moment to consider the advantages of going with the devil they already know.