3 Expected Post-Election Changes - No Matter Who Wins

As Barack Obama closes in on the Democratic presidential nomination, investors should focus their minds around one uncomfortable fact: Whether it’s Obama or Republican John McCain who wins the White House, expect some policy changes that won’t sit well with investors - or with the U.S. economy.

This could make for several rough years for U.S. investments, underscoring yet again the importance of searching out profit plays overseas.

That’s why it’s crucial that we understand just what each candidate is likely to do should he reach office. Interestingly, there are three areas where the two presidential hopefuls seem to be in agreement. Indeed, no matter which candidate reaches the White House, investors can expect there to be:

• An introduction of a “cap-and-trade” carbon-emissions-control system.
• Higher taxes.
• And stepped-up regulation of the U.S. financial-services sector.

Warming Worries Will Spawn Emissions Regs

Of all the anticipated changes, the most widely publicized is the expected introduction of a so-called “cap-and-trade” carbon-emissions-control system. Both Obama and McCain favor such a system and Congress is currently drafting legislation that is not expected to pass this year (while George W. Bush is still President), but to form a template for legislation from a Democrat-controlled Congress to be signed by either Obama or McCain in 2009.

The most economically efficient way to curb carbon emissions is by means of a carbon tax. Such a tax would penalize emissions by polluters at a flat rate per ton, and could be offset by reductions in other taxes - a decrease in the corporate tax rate, for example - thus neutralizing its overall economic effect.

Provided the tax was set at a moderate rate, it would provide incentives to shift from carbon-based fuels to other energy generation systems, while the market itself would determine which carbon uses would be discontinued and which were too expensive to change. It wouldn’t matter too much at what level the tax was initially set, since a moderate error in setting the level would produce only moderately suboptimal polluter behavior, as the incentives produced either a little too much clean-up and consequent economic damage, or not quite enough.

The carbon tax is unpopular with politicians, because of the word “tax.” From bitter experience, they have found that raising taxes leads to unpopularity and, ultimately, to electoral defeat. Even if other taxes are lowered, the squawks of the complaints and protest of the losers are always much louder than the contented purring of the winners. That explains their preference for a “cap-and-trade” emissions policy, under which politicians pretend to give something away, providing licenses to pollute, which can then be traded among users.

The main difference between the cap-and-trade schemes of McCain and Obama is this: McCain would allow the government to give out permits to polluters while Obama would auction off permits.

At first glance, McCain’s approach appears more pro-business, but consider this: If the government gives out the permits, it gets to choose which companies get what permits. That creates a huge new playing field for lobbyists and opens the door to all sorts of new opportunities for corruption, as polluters “compete” to gain the political favor of an emission permit allowance. Already in the draft Congressional legislation provision is being made for favored groups to be given special allowances of emission permits - essentially the same as the government giving them cash, as the permits will have value.

Under Obama’s proposal, however, the government will auction off the permits. That will ensure that their price is set by a market process, and that companies neither gain nor lose by their special access to legislators. It’s a much more honest process, and a much-better representation of the “free market.” And the extra revenue it generates can be returned to the taxpayers via tax reductions in other areas.

Indeed, the only disadvantage of Obama’s proposal compared to a carbon tax is that the government has to determine initially how much carbon should be emitted. That is a very difficult parameter to determine, and an error of 1%-2% in either direction can have a huge effect - as shown by the 2004-07 European Union emission permits, where too many were given out. As a result, the prices in the permit trading market dropped 98% in a couple of weeks, as companies discovered there were ample permits for all. A market with that degree of uncertainty is far more likely to result in corporate-finance game playing than in any serious reduction in emissions.

McCain’s proposal contains a number of additional potentially detrimental features. Under it, reducing emissions in emerging markets can satisfy emissions requirements. But as the European Union has discovered, one spin-off effect has been the creation of a thriving market in Chinese environmental-cleanup scams. Further complicating the scene is the fact that some industries would be partially exempted in order to allow for transitional difficulties - providing another fertile field for government meddling and corruption. Still, even with Obama’s proposal, a “cap-and-trade” system is likely to do significant economic damage, and given the fact that legislation would need to be drafted by Congress, the chance of huge economic distortions must be considerable.

The Taxman’s Bigger Bite

A second area where both candidates essentially agree is that taxes will be higher. McCain obfuscates this, because he needs to preserve his relations with the Republican “base.” But he has made it very clear that fiscal discipline in terms of balancing the U.S. federal budget is his most important economic objective. And he favors further activity in the Middle East, a fact that’s likely to involve an expansion of defense spending. Since, even without a recession, the federal deficit in the years to September 2008 and 2009 will be close to $500 billion, McCain’s balance-budget objectives cannot be achieved without tax increases, both reversal of most of the 2001 and 2003 tax cuts and increases beyond that.

Obama has been more up-front about his desire to reverse the 2001 and 2003 tax cuts, and to impose Social Security contributions on incomes above $200,000. Since he also favored U.S. Rep. Charles B. Rangel’s bill, which increases income taxes on higher incomes, an Obama administration could potentially increase the top marginal rate of income taxes increase from 35% to 52%.

Obama also favors an increase in the capital gains tax rate from its current 15% to at least 20%. On the positive side of the budget, an Obama administration would presumably save money in the Middle East. And his health-care plan, which mandates coverage for children but not for adults, would presumably be somewhat cheaper than Hillary Clinton’s plan.

Nevertheless, tax increases are inevitable no matter who wins in November. And if Obama were to win, those new levies might include a supercharged capital-gains tax and even dividend-tax increases - either of which could hammer U.S. stock prices.

Financial Services Scrutiny

A third area of agreement between the candidates is in greater regulation of the financial-services business. From the viewpoint of a retail investor, this may be a good thing: After all, who could object to fewer scams and rip-offs, or-less-egregiously overpaid investment bankers?

However, the ideological impetus behind such regulation differs significantly. Obama believes in regulation in general, but he has no great objection to investment bankers themselves (many of whom are his ardent supporters).  But McCain, by contrast, despite being from the party of low regulation, has no great objection to regulation in general and displays a visceral dislike of investment bankers.

Both candidates would probably press the U.S. Federal Reserve to impose tighter leverage restrictions to deter further blowups of The Bear Stearns Cos. Inc. (BSC) type operations - even though such central bank initiatives ultimately would harm taxpayers. And Obama has seemed sympathetic to the argument that the 1999 repeal of the Glass-Steagall Act separating commercial and investment banking was a bad idea.

Either way, investments in U.S. securities may be somewhat safer for the retail investor, particularly the retail investor in mortgaged-backed securities, asset-backed commercial paper and other exotica, but the stocks of financial-services companies themselves are likely to be long-term dogs.

Finally, whichever candidate wins, interest rates are likely to rise. Neither candidate wants them to, but the policies of the past decade - keeping rates as low as possible and hoping that inflation doesn’t reappear - seems close to bankruptcy. At some point, the Fed will have to raise rates, and that will have a knockout effect on both stock prices and on the U.S. economy.

If there’s one prediction I can make from this analysis, it’s this: It looks very much to me like there will be a rough few years ahead in the United States, whichever candidate wins.

How fortunate that we can escape almost all of these difficulties by investing in emerging markets.

[Editor’s Note: Money Morning Contributing Editor Martin Hutchinson has personally interviewed the economic advisors for candidates McCain, Obama and John Edwards for our ongoing “Election 2008” series, and concluded that Obama and McCain would be the best candidates for investors. Hutchinson wrote about the “Potomac Primaries” in mid-February. For a full report on the “presidential profit plays” that was derived from Hutchinson’s research, please click here. The report is free of charge].

Comments

[seeksome]

If cap and trade take effect this country is going down the tubes it will put everybody that I know who owns a business out of business I can not believe that even if the republican wins we are screwed it is a very sad state of affairs God help us!To get what you want at the price you want to pay go to:seeksomething.com

[elcopone]

seeksome: if cap and trade is going to "put everyone you know who owns a business out of business", the people you know must not be good business people. View every problem as an opportunity.

Martin: You layed out the downside very well it true pessimistic style, how about the upside?

[statePoet1775]

This is so sad because it was so avoidable. Businesses,investors and government love fractional reserve banking because of its ability to create money from nothing. But this loots the middle class and the poor via inflation and the boom bust cycle.

If you say this is necessary for progress then ask yourself this question: Were the Roaring 20's so good that they were worth The Great Depression, The New Deal, and World War II?

[Fozzie]

Change is inevitable. To continue with solid economic growth in the long term (ie. 50 years), we need to retract, rethink, and regroup.

The Carbon tax is necessary, but would be more effective if it was a carbon neutral tax, where the income would be used to fund the looming social security gorilla and the cost would incite taxpayers to pollute less.

[fg144331]

I agree with the upcoming problems, I am still voting for RON PAUL,
when you listen to what he has to say, he will make changes the other two will not! Back to the old Tea Party idea.

[mlangner]

Martin - I am not so certain I agree with your assesment that a Carbon Tax is the most efficient mechanism to reach our emission goals. Perhaps initially we can get similar performance, but over the long run a cap and trade system should work better.

First off - Taxes are a notoriously poor mechanism for managing societal goals - mandate by legislation is much more direct - and thereby efficient mechanism. A cap and trade system is not a tax, its a mandate. The whole goal of cap and trade is to mandate how much carbon emissions we emit collectively in order to reach a common good. So when you say that the disadvantage of Obama's approach is that the government has to set the amount of carbon emitted - that's exactly what they are supposed to be doing because that's the whole reason we are doing this. Any Carbon Tax will be judged by the amount of carbon emissions we reduce anyway because thats the goal of the tax too - its just that its a much less direct mechanism to reach that goal because its a behavioral response approach. Take legislation to force auto manufacturers to put seatbelts in cars - the government (we the people collectively) determined that in order to protect the common good of Americans (not flying through your windshield in an accident) auto manufacturers were required to put seatbelts in cars - no funny business about taxing cars without seatbelts to encourage the availability - and then a review process to see if we were getting enough cars with seatbelts and then a tweak of the tax (all while lobbyist are busy corrupting the process) - just a direct mandate to solve that problem - boom, next piece of business.

The trade part just allows a mechanism to accomodate those that cannot or will not cut emissions to their fair share (which effectively eliminates the externalities that business foists on competitors or the commons) or reward those that can operate below their fair share (which is a business by business decision).

Taxes should be used to fund the operations of government - not as a behavioral "stick".

Second - Even if you can set a carbon tax at the right level to elicit the behavioral response you seek (which in this case is a collective carbon output) - they are static - so they go out date quickly - which screws up the behavioral response. Non-indexed Social Security contributions are a perfect example...

[ValueHunter]

What a laughable bunch the "free marketeers" are. No regulations! No regulations! And oh, by the way, we are too big to fail, so if we f**k up the taxpayer has to bail us out. Bite me.