A long held maxim in the investment business is that bonds issued by stable governments have no default risk because governments have unlimited taxing authority. The ability to repay debt is simply a function of collecting tax revenues.
The fact that the Greek government is presently discussing the terms of its “non-default” default challenges this maxim. With the debt rating of the United States government having been downgraded last year, and many European nations having had their debt ratings similarly reduced a few weeks ago, it seems reasonable to contemplate the “unlimited taxing authority” maxim even further.
Is it no longer true that the United States Government has unlimited authority to tax its citizens and corporations? Certainly there have been no legislative changes suggesting any modification to this authority. So what is happening? Why not just raise taxes to eliminate the projected deficits and give comfort to the rating agencies? What are the politicians waiting for?
As I think this through, two related notions come to mind. The first: the authority to tax remains, but the will to tax is not there. The second: global competition suggests that corporations can easily shift operations to lower tax locales/countries and this gives politicians similar pause.
Why not the will to tax? I believe it is because sufficient uncertainty exists about the impact of tax rates on economic activity. This being the case, a reasonable level of timidity on the part of policy makers exists lest they find even less revenues collected than at the original, lower tax rate.
The second issue is pretty straight forward and it became apparent as the states of Indiana and Wisconsin attempted to lure Illinois businesses to their states with lower tax rates following the rise in tax rates that Illinois implemented in 2011.
In the long run, this restraint on tax should serve the republic well as it relates to long term economic growth.
All comments and questions are welcomed.
Robert M. Bilkie Jr., CFA