“Using the term nonlinear science is like referring to the bulk of zoology as the study of nonelephant animals”
–Garnett Williams
If you are a proselyte of complexity theory and nonlinear dynamics you’re always on the lookout for tangible real-life examples to help internalize and further crystalize your understanding. Abstract conceptualization is a hollow meal.
Earlier this week I tweeted out a new-to-me video on the ecological transformation of Yellowstone National park set in motion by the introduction of a top level predator.
In the case of Yellowstone, the reintroduction of wolves to the park catalyzed a spectacular “trophic cascade” that not only restored balance to the local ecosystem but substantively changed its physical geography.
The temporal procession of events occurred linearly but the network effects were significant and ‘the signal’ was amplified as it propagated. In ecological transformation terms, the developments were decidedly nonlinear.
I don’t know if the proffered explanation of events is full or partially true but you should watch the short video.
Go ahead … it’s Friday … it’s sunny … WMT is up 11%, ATH’s are plentiful, Industrial Production hit a 3Y high, Builder Confidence is back to flirting with cycle highs, we’re tracking for a 6th consecutive quarter of growth (gdp) accelerating in 4Q and the House passed tax reform before Thanksgiving … you have the extra 3 minutes.
I’ll wait … TROPHIC CASCADE VIDEO
I’m inclined to simply leave it there this morning. Clumsily cross-walking that trophic elegance to a market metaphor somehow feels like it adulterates its quintessence.
Mother nature probably doesn’t recognize and distinguish “week days”. It’s a human contrivance, but so is “work” and “pay checks” so …
Back to the Global Macro Grind…
Yesterday, alongside our Macro Policy team, and as the House was passing the TCJA, we hosted a Tax Reform update call in which we detailed the implications for consumer spending, domestic growth, productivity, corporate profits and housing.
One of the primary revenue sources in the reform proposals – and one of the primary points of contention among legislators - comes from the repeal of State and Local (& property) Taxes deductions, or SALT.
SALT deductions (along with the Mortgage-Interest Deduction) are only relevant for the ~30% of taxpayers who itemize on their taxes. And they are acutely relevant for upper-middle income earners in High Tax, Higher Income, Higher Home Value states.
Think coastal states like CA, NY, NJ and CT.
Indeed, SALT deductions for CA, NY, and NJ alone totaled $220B in the latest data and the Treasury estimates the costs (i.e. lost revenue) for the deduction of Property Taxes and other State and Local Taxes will total $485B and $1T, respectively, over the next decade.
So, what happens when you introduce a SALT “wolf” into the Tax System?
Like any integrated ecosystem, Tax Policy doesn’t exist in a vacuum and the incentives embedded in the tax system get entrenched and manifest in very tangible ways at the state, local and community level.
The graphic below shows a stylized version of the Impact Cascade from SALT to local economies.
If you start at the top and follow clockwise, you can see how the impact propagates and entrenches itself in self-reinforcing fashion.
The implications of a reversal in that cycle are not particularly good nor particularly difficult to see manifesting in some fashion (see the sidebar in the chart).
If you’re going to prioritize corporate tax relief while successfully painting the individual tax code with a populist brush, the base question becomes a relatively simple one:
What is the source pool of funds for redistribution? …or, more colloquially, who can we take money from?
The answer, in large part, is upper middle income earners – particularly in SALT states. Not necessarily the top 5% or 1%, but the rest of the top quintile.
Below is an illustrative case study for NYC where we mapped adjusted gross income by zip code to the change in after-tax income implied by the reform provisions.
We used an IRS dataset with tax return data for over 27,000 zip codes which includes zip code level data for Adjusted Gross Income, and SALT, Mortgage Interest and Property Tax deductions. We adjusted the parameters to reflect the provisions in the House and Senate reform proposals, and calculated the after-tax hit to income by zip code from the plan.
As can be seen, on average, taxpayers in zip code 10282 are likely to see a -7.5% (-$31,572) reduction in after-tax income as a result of the House proposal. This exemplifies the probable impact to similar SALT locales.
To be clear, this isn’t meant to be a sob-story for the relatively well-off. It’s meant as an objective analysis of the provisions as they stand currently (the conclusions could obviously shift considerably if and when the ink is dry) and, for this morning, I’ve purposefully focused the discussion on some of the negative implications.
Of course, the broader benefit is likely to be diffuse but net positive in aggregate and repatriation and corporation friendly reform is likely to support further asset price inflation so maybe this whole thing just devolves into another “buy stocks” narrative and that upper quintile can just recoup any tax hit via higher equity values.
Anyway, below is the simplified reduction of the winners and losers from reform with an eye towards housing in particular.
Our immediate-term Global Macro Risk Ranges (intermediate-term TREND views in brackets) are now:
UST 10yr Yield 2.30-2.42% (bullish)
SPX 2 (bullish)
RUT 1 (bullish)
NASDAQ 6 (bullish)
VIX 8.84-13.24 (bearish)
USD 93.49-95.19 (bullish)
Oil (WTI) 54.33-57.99 (bullish)
Gold 1 (bearish)
Copper 3.01-3.15 (bullish)
Have a great weekend,
Christian B. Drake
U.S. Macro Analyst
