A Global Minimum Tax Will Intensify Trade Disputes

By Thomas Kirchner, CFA

• 15% minimum corporate tax decided at G-7.

• Subsidies to replace tax incentives.

• Trade wars will intensify over subsidies.

• Implementation in the U.S. is unlikely...

The introduction of a global minimum tax rate may sound like a really good idea if you are a head of a cash-strapped government at a G-7 meeting where everyone has been concerned about their eroding tax base. However, new tax rules can have unintended consequences. Their proponents often have no experience with business decisions and are more focused on vague notions of tax fairness rather than the hard practicalities of decision-making when facing conflicting international tax regimes. Of the seven core nations at the G-7, only one is represented by a leader with private sector experience worth mentioning: Italy's PM Mario Draghi spent three years at Goldman Sachs and a few years as a consultant at the World Bank. We put little value in terms of private sector business expertise on UK PM Boris Johnson's decade as a journalist, apparently without any management responsibilities, or President Biden's two years as a public defender in the 1960s. Therefore, a tax regime heavy on pathos and light on practicalities should be expected.

With the new U.S. Administration seeking to increase corporate taxes, the U.S. withdrew its long-lasting opposition to the OECD proposal for a global minimum tax, paving the way for its adoption by the G-7. In fact, Treasury Secretary Yellen has her own 15% minimum tax rate proposal, which could be even more draconian than the OECD one.

How the new minimum corporate tax works

The global minimum tax framework proposed by the OECD and adopted by the G-7 has two pillars [i]:

1. The first pillar seeks to reallocate profits to markets where the economic activity occurs. This seeks to eliminate the creation of intellectual property holding subsidiaries (aka “patent boxes”) in countries with low tax rates, and thereby reducing the profits in high-tax countries via license payments to the patent boxes.

2. The second pillar is the actual minimum tax. It acts as a tax equalization: if a company pays less than a 15% tax rate in its foreign subsidiaries, then the home country will charge an extra tax so that the total tax increases to 15%. This is meant to reduce the incentive for moving subsidiaries to low-tax jurisdictions.

The tax would apply only to the largest companies who have more than a 10% margin. “Large” appears to refer only to the largest 250 companies – at least for now, rules tend to expand once in place, after all.

What the margin is on is unclear – net margin on sales, EBITDA margin on sales, return on equity, return on invested capital? Whatever the metric, one company that has caused the ire of many politicians for its creative use of low-tax jurisdictions will not be included: Amazon.com does not make 10% on those metrics. The only way to have Amazon included would be to apply the minimum tax to each business segment. That is something under serious consideration and, if actually implemented, would make such a minimum tax a bureaucratic nightmare.

The main difference between the OECD and Secretary Yellen’s minimum taxes are their scope: Yellen's minimum would apply to all companies; the OECD proposal only to the world's largest companies, with a disproportionate, if not exclusive, burden borne by U.S. tech giants.

The devil is in the details

The tricky question is what taxes exactly count toward the minimum. After all, tax rates themselves are always secondary considerations, exemptions and calculation methods are the main drivers of the taxes effectively paid. And as one may expect, the minimum tax already has a number of pet peeves excluded.

Most notably, the Digital Services Tax (DST) that Europeans want to impose on U.S. tech giants would not count toward the 15% minimum. Therefore, the effective minimum for tech giants will be higher than 15%. Europeans propose to abandon the DST in exchange for the minimum tax but experience shows that a tax, once proposed, will eventually be implemented.

Other taxes, such as real estate taxes, labor-related taxes, business activity taxes, value-added taxes, franchise taxes and the like also would not count. This matters a lot, because by some estimates, profit taxes only represent one quarter of the total tax burden of large, global enterprises, with the rest coming from such other taxes that generally are ignored in the debate about “fair” tax burdens [ii]. Therefore, charts that have circulated recently showing a steady decline in corporate taxes over the last five decades are misleading because they ignore the simultaneous increase in other forms of taxation.

The second pillar in particular can have severe impacts depending on how poorly it is implemented. For example, does each foreign subsidiary have to pay a 15% minimum tax, or can losses in one country offset profits in another, so that foreign subsidiaries pay the 15% minimum in the aggregate? This is more than a technical detail – it can make the difference on whether or not entering a foreign market makes sense or not. If each subsidiary has to pay a 15% minimum tax, it could make more sense for companies to not enter markets through subsidiaries but to use foreign partners. Effectively, this rule alone can lead to a severe de-globalization of global enterprises.

The Biden Administration currently supports a country-by-country minimum tax calculation. We believe that one of the unintended consequences might be the further export of U.S. jobs. Long-term investments outside of the U.S. will become less attractive for U.S. firms compared to locally-based firms that can fully utilize the initial tax losses such investments entail. Therefore, crucial elements of the supply chain that are currently owned and controlled by U.S. firms will slowly fall under the control of foreign firms, with eventually entire supply chains being expatriated and U.S. firms becoming mere importers of finished goods.

Another uncertainty is the treatment of REITs and investment funds. Alone the suggestion that a fund-level corporate tax might be imposed shows how little economic sense is in the minds of policymakers. It is only a matter of time until someone discovers mortgage-backed securities, CLOs or other securitizations as potential targets for a corporate tax.

Tax incentives become pointless, shift revenue from one country to another

Tax incentives are a powerful instrument used by governments to attract business. A global minimum tax will negate any such incentives. For example, if the state of Georgia tried to attract investment by a foreign sports car manufacturer in Atlanta through tax abatement, any such benefit would be offset by the Federal government which would collect a higher tax. In fact, the tax revenue would simply shift from the State to the Federal government. A similar shift in tax revenue would also occur internationally should the Federal government offer similar incentives. The car company's home country would then increase its taxes to the minimum and collect the tax incentives offered by the U.S.

In particular, Biden's proposed 10% “Made in America” investment tax credit would end up in the coffers of foreign tax authorities if paid to a foreign company investing in a U.S. plant and if that company is then hit with the 15% minimum rate in its home country.

Rethinking subsidies

Such an international shift of tax revenues is probably not what the G-7 leaders have in mind, but it is an inevitable consequence of the proposed minimum tax regime. The implications are widespread, because tax incentives are used widely to support investment in favored areas: accelerated depreciation for energy investments in the U.S., tax support for renewables pretty much everywhere, favorable tax rates or exemptions for agriculture. Traditional tax incentives will become appealing only for domestic enterprises.

But governments are creative, too, and if they cannot attract foreign investment through the traditional tax incentive schemes, they will create new incentive schemes. The most obvious coming to mind would be subsidies masked as social spending: for example, rather than making employers pay for health care and other social taxes, the government might pick up the cost disguised under welfare programs. This will lead to a reduction in unit labor costs, which can then be used through the clever use of transfer pricing rules to shift profits elsewhere.

The possibilities are endless, and it is clear that the winners will be the lawyers and tax advisors, for whom a new era of record billings is likely to begin. Whether any country will be better off remains to be seen.

Why trade wars will escalate

With tax incentives gone and governments coming up with with new and inventive subsidies, others will push back over such “unfair” trade practices. Both the WTO and European Union have rules about state aid. In fact, it's ironic that the 40-year battle between the EU and U.S. over subsidies to Airbus and Boeing is winding down just as governments are creating a tax framework that would make such subsidies more appealing in the future. This war intensified after a 2019 WTO ruling that authorized the U.S. to levy tariffs on the EU and at the same time authorized the EU to levy tariffs on the U.S. The absurdity of this ruling appears to have been grasped even by policymakers, who are now ready to do a deal [iii]. We note that while the press pins the beginning of the dispute to 2004, when the current case at the WTO was filed, the disputed subsidies actually go back as far as the 1980s. Most of the key decision-takers from back then are not even alive any more, and none hold public office.

We believe that the Airbus/Boeing trade debacle is a template for what lies ahead. As governments slowly come to grasp what their minimum tax decision has done to their ability to incentivize investment, they expand the use of subsidies, many of which will run counter to WTO rules. But elected officials benefit from the immediate political support that such subsidies create, while the cost in the form of punitive tariffs will be borne by future administrations and taxpayers decades later. No mechanism exists to address this conflict of interest. Therefore, it will happen.

The result will be violations of WTO rules, retaliatory tariffs followed by more rule violations and compensatory tariffs. We may have changed the tone of international trade relations, but the substance is at risk of sliding into an escalating trade war.

Good news: it won't happen

The fanfare surrounding the announcement of the minimum corporate tax stands in sharp contrast to the low likelihood of its implementation. The City of London and Switzerland are already trying to find ways for an exemption or circumvention. Even in the U.S. it is far from certain that it will be implemented. The agreement might be considered an international treaty, which would be subject to two thirds approval by Congress, a near impossibility. If the U.S. does not participate, it is likely that many other countries will also refuse to implement it. While the EU is very likely to implement it, we expect that it will dilute the impact through rulemaking if the U.S. does not participate.

The main problem with the global minimum tax is that it is designed to target U.S. tech companies. The U.S. will lose tax revenue to other countries as a global minimum tax shifts tech giants' taxes to other countries, but it will not have the opportunity to recover the lost taxes from foreign companies operating in the U.S. because they shift profits less frequently to patent boxes. Congress is likely to recognize this asymmetry and reject the OECD proposal.

Things get really complicated if Congress passed Secretary Yellen's 15% minimum tax proposal but rejected the OECD’s. In that case, U.S. firms face a double disadvantage: companies of all sizes would be faced domestically with the Yellen minimum, and the tech giants would be hit internationally with the OECD minimum. Firms domiciled outside of the U.S. do not face such a double disadvantage. It would be unfortunate if the asymmetry that the U.S. faces in international trade would now be replicated in international taxation. It is clear that if a future administration took a similarly tough line on asymmetries as the previous one, the global minimum tax regime will make such a confrontation only worse.


[i] “KPMG report: Analysis and observations about tax measures in G7 communique.” KPMG, June 7, 2021.
[ii] Natalia Drozdiak, Alberto Nardelli, Bryce Baschuk: “U.S. and EU to End for Good Trump’s $18 Billion Tariff Fight.” Bloomberg News, June 8, 2021.
[iii] Andy Agg, Andrew Packman: “2020 Total Tax Contribution survey for the 100 Group.” pwc for The 100 Group, December 2020.

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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.

Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B216

Disclosures:
• Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
• This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
• Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
• Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798

Copyright © 2021 Camelot Event-Driven Advisors, All rights reserved.

End of Covid? Now What?

By Paul Hoffmeister, Chief Economist

• Covid cases in the United States have plummeted.

• U.S. manufacturing and services sectors are rebounding sharply.

• Inflation data is rebounding as well, similar to 2009.

• When will the Fed start raising interest rates?

• Value is outperforming growth meaningfully in 2021.

• Tax increases from Washington look on hold for now.

Covid: Are We Near the End?

New York Times on June 6, 2021: “America has essentially lifted all rules for people who are vaccinated.” (As Vaccines Turn Pandemic’s Tide, U.S. and Europe Diverge on Path Forward)

Over 50% of US population has been vaccinated.

Texas led states in reopening in March. California plans to remove all capacity limits, physical distancing requirements starting June 15.

Rebound in Manufacturing and Services

The economy is strongly rebounding.

According to surveys by the Institute for Supply Management, the manufacturing and services sectors are growing at the fastest rate in more than a decade.

Unemployment: Heading Back to Pre-Covid Levels

With the global economy reopening, the U.S. unemployment rate has collapsed from 13.1% in June 2020 to 6.2% in March 2021.

Federal Reserve forecasts foresee the possibility of a 4.5% unemployment rate by year-end 2021.

According to Bloomberg surveys, the U.S. unemployment rate is expected to reach 5.4% by year-end, 4.2% by end of 2022, and 3.9% by end of 2023.

Inflation: Oil Price Rebound and CPI

As discussed months ago, the value of oil in relation to gold (which is arguably a more stable unit of account) is useful in presaging the direction of CPI.

Continued commodity price appreciation will likely push CPI to highs not seen in a long time.

However, we are not concerned about a round of secular inflation unless gold surges meaningfully beyond $2000/oz. and the dollar weakens significantly in forex markets.

Inflation: Big Jump for Now

Prices are jumping year-over-year in the United States, Canada, and Europe.

The “surge” is due in part to the current comparison to a low base a year ago when producers and retailers slashed prices to liquidate inventories, as well as current supply shortages.

Inflation Rebound After Crisis To Be Expected

An inflation rebound after a major economic shutdown, similar to 2008-2009, is to be expected.

Taper Tantrum in Next Year? When Will Fed Shift Course?

With U.S. unemployment falling toward pre-Covid levels and inflation jumping, when will the Fed begin raising interest rates?

As 1999-2000, 2004-2006 and 2018-2019 showed, market shocks tend to follow compressions in the yield curve spread; whereas a widening spread has correlated with strong returns in risk assets.

In the coming months and years, a rising rate cycle and narrowing spread environment should be navigated with caution.

2021: Value Is Shining

Arguably, a law of financial physics is reversion to the mean. So perhaps not surprisingly, growth’s outperformance over value in recent years was long in the tooth.

Year-to-date through June 4th, the Russell 1000 Value Index is up 18.3%; whereas the Russell 1000 Growth Index is up 6.3% (not including dividends).

Conclusion: Monetary Policy, Taxes and Politics

The Covid-19 pandemic and economic shutdowns look to be behind us, while economic activity and employment are rebounding sharply – as is inflation. Aside from a new, dangerous Covid variant, the biggest threat to financial markets is a taper tantrum episode where markets get ‘spooked’ by the Fed departing from its historically dovish policy posture.

The U.S. Senate reconvenes this week, and President Biden’s policy agenda is facing resistance – notably the tax and spending plans in his infrastructure proposal and voting reforms. At the moment, their passage into law looks unlikely.

With the Senate split 50-50 and Republicans united in their opposition, the most important politicians today may be Senators Joe Manchin (D – WV) and Kyrsten Sinema (D – AZ). In a recent op-ed for his home state newspaper, the Charleston Gazette-Mail, Manchin announced his opposition to the White House’s voting reform legislation and weakening the filibuster. Underscoring the obstacles facing the White House’s policy agenda, President Biden stated in a recent speech: "I hear all the folks on TV saying, 'Why doesn't Biden get this done?' Well, because Biden only has a majority of, effectively, four votes in the House and a tie in the Senate, with two members of the Senate who vote more with my Republican friends“ (source: Bloomberg).

Democratic concerns about taxes also exist in the House. A top Democratic Congressional aide told Bloomberg recently: “The thing that is missing in the conversation about these pay-fors is where Democrats won the House. We won by primarily winning in the suburbs, which tend to be tax-sensitive areas of the country.”

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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).

Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537

Disclosures: B231
• Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
• This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
• Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC. Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach. Only your professional adviser should interpret this information.
• Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
• Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798

Copyright © 2021 Camelot Event-Driven Advisors, All rights reserved.

Strong Recovery - Value Regains its Place in the Sun

Camelot Portfolios: Special Market Update and Performance Commentary

by Darren Munn, CEO/CIO

In October, 2020 we published a performance commentary highlighting:

• The tremendous divergence in the market – growth strongly outperforming value & dividend stocks.

• Our belief this trend would reverse at some point.

• The strong performance of our strategies not focused on value/dividends.

• Our plan to improve the performance of the value/dividend-oriented strategies.

We now have another six months (November through April) of performance data to update our progress and the changes in the market. We believe the results show the change in the market we were expecting is in process and our investment plan has produced excellent results!

Progress Update - Perfection is the Goal but not the Expectation

Since we started this process back in the second quarter 2020, we can report significant progress. We believe the absolute and relative performance has been excellent!

• 100% (10 out of 10) of our Core SMA strategies outperformed their benchmark for the trailing 12 months through April 30, 2021 (net of our 50 bps management fee).

• 9 of the 10 outperformed by at least 1000 bps (10%)

• Over the last 12 months, on average 8.00 of our 10 core strategies have outperformed their benchmark each month, which we believe shows consistency.

• Based on the asset levels in our strategies, approximately 90% of our AUM have outperformed their benchmark for the trailing 12 months.

• Premium Stock Dividend has outperformed by 16% over the last 12 months.

• Premium Stock Growth has outperformed by 38% over the last 12 months.

• Opportunities Income has outperformed by 13% over the last 12 months.

• Core Income has outperformed by 20% over the last 12 months.

• The Camelot Event Driven Fund (EVDIX) is 1st percentile in its category for the trailing 1, 3, 5, 10, and 15 year periods (as of April 30, 2021) according to Morningstar!

In October we wrote:

“At the same time, we believe investors have the insatiable desire to “do something” even if the action provides little discernable value. Right now, investors are giving up on some of the high dividend parts of the market. We are not giving up on the high dividend part of the market, but we are going to change our assumptions & our selection process because some things will never change:

• We believe earnings & valuations still matter and will eventually be recognized by the market.

• We believe speculative investing behavior will eventually be punished.

• We believe parts of the market left for dead will adapt & recover.

We are determined to “do something that adds value.”

We believe the results of our strategies prove the strength of our discipline and investment process. Instead of chasing performance in Large Cap Growth & Technology, which many did, we “did something” we believe added value. We will continue to strive to manage our strategies with discipline and excellence.

Market Update

In our last update, we showed 1, 3, and 5 year heat maps showing the strong outperformance of Large Cap & Growth over Small Cap and Value. Here is an update.

Source: Morningstar.com/markets 05/18/2021

The strong outperformance in Small Cap and Value over the last 6 months has completely flipped the 1-year chart and has significantly narrowed the divergence over the past 3-5 years. Even better, the absolute performance is now nicely positive for the Small Cap and Value parts of the market versus the negative numbers shown last time.

Based on valuations and historical precedent, we believe this relative performance shift in the market is likely to persist for an extended period of time, maybe even several years.

But what about absolute returns & risk?

Sometime here in Q2, 2021, the U.S. GDP will recover to where it was pre-COVID. However, the S&P 500 is nearly 30% higher that it was last year when U.S. GDP was at the same level, which seems challenging to reconcile. We believe there are three primary reasons:

1. Corporate earnings growth – margin expansion

2. Lower Interest Rates

3. Quantitative Easing & Stimulus

While we continue to expect very strong earnings growth in 2021, we believe the margin expansion many companies experienced has likely peaked and will be pressured by higher labor and materials costs. As interest rates have already started to recover from the historic lows in 2020, be believe the greater likelihood is for rates to move higher from today’s levels over the next 1-2 years. We also believe the liquidity created by QE and government stimulus will start to taper in the coming months. So the tailwinds to market growth over the last year will all likely dissipate or even reverse over the next few quarters.

We believe this means there is an elevated level of risk in the market, especially in the more speculative & highly valued areas like Technology, SPACs, Electric Vehicles, and other companies that benefited from COVID shutdowns or from the massive influx of liquidity in the system.

We are still finding opportunities in companies that traditionally pay higher dividends and expect continued recovery, both in the level of dividends and market prices. With real yields on Treasuries currently negative, these types of stocks will likely attract investors as their economic recovery takes hold.

This could lead to the opposite scenario from what we saw last year – strong GDP growth but weak market growth; positive returns for Value but negative returns for Growth.

In summary, we believe the market growth over the next 1-2 years will be less exciting than the last 3 years and may struggle to get to double digits. There will likely be extended periods where the market chops around in a range without making much progress as the valuations catch up to market prices. We also believe this choppiness will provide opportunities for our investment process to further prove its’ value.

Conclusion

We believe our performance results indicate the bold action we took last year helped restore and build on the strong, dependable track record we strive to maintain at Camelot. Our Portfolio Manager team is more integrated and collaborative, providing additional opportunities for us to capture in our strategies.

We will work diligently to build on the current momentum as we strive to deliver a great investment experience for the clients you serve. Thank you for the trust you place in us and for the pleasure of serving you.

With Extreme Gratitude,

Darren Munn

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Disclosures:

• Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

• This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

• Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC. Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach. Only your professional adviser should interpret this information.

• Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client's investment portfolio.

• Approved – B224

Get Ready for the Taper Tantrum

by Paul Hoffmeister, Chief Economist

• Vaccination numbers keep climbing; economies keep reopening.

• Massive government support and the fading pandemic have contributed to a historic recovery.

• That massive support may start to be unwound during the next year, threatening the equity outlook.

According to USA Facts, approximately 45% of the US population (nearly 150 million Americans) have received at least one Covid-19 vaccine dose; and 30% have been fully vaccinated. At the same time, economies continue to reopen. The most significant news recently came from the European Union, with its plan to welcome foreign tourists next month in time for the summer travel season.

All the while, the Federal Reserve is maintaining its zero interest rate policy (“ZIRP”) and bond buying programs, and the U.S. government has spent nearly $6 trillion, borrowing from the future to support the economy today.

The confluence of massive government support and the fading pandemic has contributed to an 89.2% rally in the S&P 500 from its closing low on March 23, 2020 through last Friday. And year-to-date, not including dividends, the S&P 500 is up 12.7%.

Aside from a new, unstoppable Covid variant, the biggest threat to equity markets may be the unwinding of the extraordinary economic support that we see today. That threat may not be imminent, but it could erupt within the next 12 months or less.

On the fiscal side, we are beginning to see the political limit to the outsized spending. Last week, Democratic Senator Joe Manchin, referring to the White House’s $2 trillion infrastructure proposal, said: "It's a lot of money, a lot of money.. Are we going to be able to be competitive and be able to pay for what we need in the country? We got to figure out what our needs are and maybe make some adjustments… We're at $28.2 trillion now, debt, so you have to be very careful. There's a balance to be had here.”
Note, with Democrats controlling 50 seats in the Senate, Manchin is the political margin, i.e. the critical fulcrum vote that will likely decide policy until the next Congress convenes in January 2023. For their part, Republicans have proposed a $600 billion counter-offer for infrastructure. The easy spending days appear to be over, for now.

On the monetary side, Federal Reserve officials are maintaining their dovish posture. On Monday May 5, Federal Reserve Governor Michelle Bowman said, “Despite the progress to date and the signs of acceleration in the recovery, employment is still considerably short of where it was when the pandemic disrupted the economy and it is well below where it should be, considering the pre-pandemic trend.” This dovetails Chairman Powell’s public statements weeks ago that the economy is not yet out of the woods.
But, the Fed’s median forecast for the unemployment rate is for a decline from 6.1% today to 4.5% by year-end. If that level is reached by December, it will not be far from the 3.8% rate of unemployment that the economy was experiencing just prior to the Covid outbreak and lockdowns.

Perhaps that will be the point where the economy will look to be “out of the woods”. This suggests that during the next 6-9 months, the Federal Reserve will begin to telegraph a monetary unwind – of its bond purchase programs and ZIRP.

Last week gave us a glimpse of what this threat may pose to markets today. Treasury Secretary Yellen said in a video released last Tuesday that interest rates may need to eventually rise to ensure that current fiscal ‘stimulus’ doesn’t overheat the economy. At one point that day, the S&P 500 was down nearly 1.5% from its closing level on Monday.

If such a seemingly innocent remark can cost the market that much, how much would an official departure from the current monetary posture actually cost? 10%? 20%?

Investors should reflect on the market tantrums of 2018 to gauge the risks ahead to assess possibly a worst case scenario. In both February and then the fall of that year, while the Fed was raising interest rates, it began to telegraph even more aggressive rate increases. As a result, we witnessed a nearly 10% and then 20% decline in the S&P 500.

In sum, the ”easy gains” in the equity market are very likely behind us – as the economy and financial markets experienced a historic natural disaster/recovery scenario -- and future gains may be much more difficult to come by. If anything, the risk-reward profile for equity investors today appears to be asymmetrically unfavorable.

Tax Update:

President Biden said last Thursday that he wants to see the corporate tax rate increased to somewhere between 25% and 28%. This is a soft backpedal from the 28% that the White House was initially advocating, and is likely due to pushback from within the Democratic Congressional Caucus. Senator Manchin is now on record, for example, to be in favor of a 25% corporate tax rate.

What’s unclear is where moderate Democrats stand on capital gains and estate taxes. President Biden has proposed raising the capital gains tax rate to the top ordinary income tax rate. Under this proposal, the top income tax rate would be raised to 39.6%, and therefore so would the capital gains tax. Adding the 3.8% Medicare surtax, the top capital gains tax rate would rise to 43.4%. Biden also proposes eliminating the stepped-up basis on estates passed to heirs. The backpedal on the corporate tax and quiet surrounding capital gains and estate taxes suggest that a new tax plan will not pass soon; it’s more likely that the plan will be passed during the fall.

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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund  (tickers: EVDIX, EVDAX).

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B219 // Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537

Disclosures:
•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach. Only your professional adviser should interpret this information.
•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
•       Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798

Copyright © 2021 Camelot Event-Driven Advisors, All rights reserved.

How Tax Hikes Will Be Confiscatory

by Thomas Kirchner, CFA

• Confiscatory tax rates of 87% result from elimination of the step-up basis.

• France's “supertax” President was ousted after one term.

• Nonsense academic studies appear to justify tax hikes.

• Offshore tax evasion is largely a myth.

Tax hikes are coming. Key proposals by the White House involve an increase in long-term capital gains rates to income tax levels, an increase in the corporate tax rate, and an elimination of the step-up basis on estates [i]. Taken together, they have the effect of creating a confiscatory tax environment. We look at how such confiscatory tax regimes have failed in other countries in the last decade and discuss some of the academic studies that claim to show massive tax evasion by the wealthy. Finally, we debunk the widely-held belief in offshore tax evasion by the wealthy on a massive scale.

Confiscatory rates justify abolition of the estate tax

A key element of the Administration's tax hike proposal is the elimination of the so-called step-up basis. Under current tax laws, a deceased person pays an estate tax of up to 35% on assets upon death. The heirs then receive what is left, and their tax basis reflects the value of the assets upon receipt. The U.S. differs with this approach from the rest of the world where not the deceased person is taxed, but the heirs on their respective share of the inheritance. Hence, the term “inheritance tax” rather than “estate tax” is used everywhere else.

The problem with the elimination of the step-up basis lies in its combination with the estate tax and the proposed higher tax rates on long-term capital gains, which will lead to overall tax burdens of nearly 90%.

A simplified example illustrates the toxic interaction of these three taxes. Consider an estate worth $100 million that consists of founders' shares in a business, so we can assume a tax basis of zero. Upon the death of the founder, an estate tax of 35% is due. For simplicity, we ignore the current $10 million exemption, which is going to sunset in a couple of years anyway.

After paying the estate tax, the heirs will be left with $65 million. The problem is that most heirs won't have an extra $35 million lying around that they can hand over to the IRS. So, they will be forced to liquidate the estate. With the tax basis of the shares at zero, they will need to pay $52 million in long term capital gains taxes if they are located in high-tax states such as New York or California. Add to that the $35 million in estate tax, and the total tax burden is $87 million, or nearly 90% [ii].

These are confiscatory tax levels. We believe that eliminating the step-up basis is a good reason for the abolition of the estate tax altogether. After all, it leads to a triple taxation of income: corporate taxes are paid on the profits of the business. Capital gains are merely the discounted cash flows of the after-tax corporate earnings, so that capital gains taxes are already a form of double taxation. Taxing such gains again with an estate tax then amounts to triple taxation.

Parallels to the French tax debacle

Former French President Hollande gained infamy for not only stating that he hates rich people, but also for acting this way. In 2012, he introduced a 75% “supertax” on earners over 1 million Euros, who were faced with a total tax burden, including social security, of well over 90% [iii]. He found out the hard way that such confiscatory taxes don't work: many high earners moved to London or Geneva and conducted their business from there; those who stayed behind avoided realizing gains in anticipation of a future repeal.

Actor Gerard Depardieu took the most drastic step of taking on Russian citizenship. While we won't speculate which Hollywood stars might vote with their feet, we note that Senator Warren is trying to prevent this from happening by calling for an increase of the exit tax on the wealthy.

The end result of Hollande's tax hike, derided as “Cuba without the sunshine” by then little-known economic adviser Emmanuel Macron, the current President, was that an estimated 10,000 high income earners left France permanently. Despite this small number of people, income tax receipts fell €16 billion short of projections. Moreover, a mere €200 million per year was raised by the tax, nowhere near enough to offset the drop in tax revenues. Hollande had to rescind the tax two years later [iii][iv].

The confiscatory tax hikes proved to be transitory, as was Hollande, who ended up as a one-term President with approval ratings in the low teens. Permanent, however, was the damage to the French tax base, as few of the tax refugees returned.

Revenue-optimizing tax rates

The proposed tax increase on the highest income earners to 39%, when combined with state and local income taxes, will lead to total tax rates in California and New York of roughly 52%. We believe that this number is no accident. In 2014, Fed researchers published a study [v] that claimed that the peak of the Laffer curve, at which maximum government revenues are achieved, is 52%.

But just because there is a study that shows that 52% is optimal does not mean it really is optimal. After all, the French “supertax” of 75% is close to the theoretical optimum of 73% that none other than economist Emmanuel Saez calculated as optimal. That is the same Emmanuel Saez who rose to fame with his monstrous tome “Capitalism in the 20th Century” a few years earlier, which claimed that rich people were getting so rich that they were becoming a threat to democracy and advocated income tax rates in the range of 54% to 80%. Of course, we know now that while that 73% tax rate may have been optimal in ivory tower theory, in real life it was terribly suboptimal and had to be nixed.

It might be a good bet that the 52% “optimal” rate calculated by the St. Louis Fed researchers will have the same fate as the French “supertax” and turn out to be dramatically suboptimal and revenue-minimizing.

Do the top 1% really evade 20% of their income taxes?

All this talk about tax hikes comes against a background of an academic study [v] purporting to show that the top 1% of earners evade 20% of their income taxes. That claim made headlines a few weeks ago, but its dubious assumptions remained unchallenged.

Uncontested are the raw data: IRS audit data show that as you climb the income ladder the percentage of tax evasion relative to total income declines sharply. In this data, the largest percentage of tax evasion occurs just below the median income group in the 40th percentile, where taxpayers evade 6% of their income (interesting side note: half of that evasion occurs through Schedule C /sole proprietor income).

For the top 0.1% earners, tax evasion is half that rate, or 3%, while for the top 0.01%, tax evasion is less than 1% of income. To us, the raw data suggest that the system works: penalties for tax evasion become more severe as the amounts evaded increase, with jail time being a realistic prospect for 7-figure evasion. Not to mention that legal ways to minimize the tax burden through deferral and shelters increase with incomes. Therefore, we would expect that the top of the income pyramid has very little evasion.

Of course, the data runs counter to the narrative that the rich don't pay their fair share. To make the data fit the narrative, the authors of the study took the percentage of tax evasion found by those IRS auditors who come across the most tax evasion and applied that rate to everyone. The assumption behind that approach is that the rate of tax evasion is the same for every income group. The outcome is the headline-grabbing result that the top 1% evade 20% of their taxes.

However, as we pointed out, penalties increase as the amounts evaded become larger, so the assumption of a uniform rate of tax evasion for all income groups is highly questionable. Moreover, it runs counter to the actual IRS data. In fact, the methodology is a simple trick that will always yield sensational headlines. For example, if we take those police officers who encounter the highest incidence of violent crime and then apply that percentage to all demographic groups, we find that the “adjusted” violent crime rate shows massive “undetected” crime. With this dubious approach, the top 1% of earners will commit massive amounts of “undetected” violent crimes, as do the university professors who create these types of nonsense studies. The differential between actual and theoretical will be largest in the group that has the smallest actual incidence. The policy response will be to increase policing of those groups who have the lowest actual incidence, because that's where the most supposedly “undetected” violent crimes happen. Most likely, this will reduce policing and exacerbate problems in those areas where the actual incidence is the highest.

The methodology is arguably useless and purely of academic interest because it applies the worst case scenario to everyone. Basing policy, in particular tax policy, on a worst-case scenario based on unrealistic assumptions is a bad idea.

The myth of offshore tax evasion

Finally, we would like to clarify a myth about offshore tax evasion that underlies many other studies. The fact is that most industrialized countries impose withholding taxes on dividends and interest on foreign-held accounts. For example, the U.S. generally imposes withholding taxes of 30% on foreigners, while Switzerland, supposedly a tax haven, imposes 35%. That means that anyone stashing away their investments in Switzerland faces a tax rate of 35%. Of course, you can get these foreign taxes back under most tax treaties. But that requires you to declare the income to your own tax authority, who will then issue a certificate that can be used with the foreign tax authority for a refund. So any American hiding money in Switzerland faces a 35% tax rate on dividends. If the person invests their hidden Swiss money in U.S. stocks, they face a 30% U.S. withholding tax on dividends, more than the 20% federal tax rate they would pay on qualified dividends on investments fully disclosed to the IRS. Of course, that's the point of withholding taxes: they are supposed to make hiding assets uneconomic. And because the assets are undeclared, their owners cannot claim a refund for the withholding taxes. In light of these heavy disincentives, we doubt the claims about the exorbitant amounts of taxes supposedly evaded by the rich through offshore accounts.

In fact, for smaller investors, the cheapest option is to simply pay the withholding tax and forego the refund. This is not because they are hiding assets, but because the cost and complexity of the refund process exceeds what they expect to recover. Therefore, if someone doesn't request a refund of their withholding, that alone cannot be taken as evidence of tax evasion, but is simply a cost-benefit tradeoff.

Moreover, in our experience, few financial advisers are familiar with the intricacies of holding foreign stocks and withholding taxes and refunds, so that many end clients probably forego significant refunds due to such ignorance.

To the extent that undeclared offshore wealth actually exists, overall tax receipts would not necessarily increase if all of it were to be declared. As discussed above, the U.S. government already withholds taxes on dividend and interest payments paid to foreign accounts. If these assets were declared, these withholding taxes would no longer be collected. Moreover, to the extent that these accounts are invested in stocks listed in other countries, taxpayers would be able to claim a tax credit for withholding taxes paid in such other countries. Depending on how the net effect of all of this would play out, U.S. tax receipts may actually decline if all currently undeclared offshore wealth were to be declared. The absence of considerations of withholding taxes in academic studies on offshore tax evasion is a red flag that these academics lack a good understanding of the complexities underlying offshore investments.

How it will end

Taxes are a hot button topic. A significant proportion of the population is convinced that the rich do not pay their fair share. Much of that is based on myths, which are reinforced by questionable studies and statistics.

Overall, there may be plenty of legal ways to defer and reduce taxes, from special IRA accounts, MLPs and REITs, 1099 exchanges or insurance wrappers to a myriad of other structures. American investors have no need to go into illegality to reduce their tax burden.

Moreover, the increase in individual tax rates may lead to a revival of the C Corp for small businesses. Rather than passing through all income to the owners, who pay a high tax rate on that income, it will make sense for many highly profitable closely-held businesses to become C Corporations and pay salaries to their owners, while the majority of profits are kept in the corporation, where they are taxed at a much lower tax rate and can grow, with these gains also taxed only at the (lower) corporate tax rate. The result of the reduction in pass-through entities would be lower income inequality, because the income is no longer reported by the taxpayer but by the corporation. This effect may be one of the reasons why the White House is adopting such tax policies.

For the tax hikes themselves, we foresee three scenarios: in a worst-case scenario, a confiscatory tax regime will be implemented. In this case, the economic boom will end. Depending on the length of such a tax regime, America may no longer be seen as the land of opportunity and IPOs by the world's most talented technologists, but as the land of confiscatory taxes. This will do long-term damage to the tech industry and, by extension, the economy as a whole. In a best-case scenario, taxes will be raised only moderately. In the third, most likely scenario, taxes will be hiked substantially but this will be undone by future elections, as the economic consequences become apparent.

[i] Greg Iacurci: “Biden wants to raise $1.5 trillion by taxing the rich. Here’s how.” CNBC.com, April 29, 2021.
[ii] Camelot calculations.
[iii] Jon Hartley; “Hollande's 75% 'Supertax' Failure A Blow To Piketty's Economics.” Forbes, Feb 2, 2015.
[iv] John Lichfield: “President Hollande bids adieu to French 'supertax' detested by the country's millionaires” The Independent, January 6, 2015.
[v] Alejandro Badel and Mark Huggett: “Taxing Top Earners: A Human Capital Perspective.” Federal Reserve Bank of St. Louis, Working Paper 2014-017B.
[vi] John Guyton, Patrick Langetieg, Daniel Reck, Max Risch, Gabriel Zucman: “Tax Evasion at the Top of the Income Distribution:Theory and Evidence.” NBER Working Paper 28542, March 2021.

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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.

Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B216

Disclosures:
•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
•       Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798

Copyright © 2021 Camelot Event-Driven Advisors, All rights reserved.