Wall Street's Credit Problems Mean Big Tax Trouble Is Coming

by: Barry Ritholtz

Here's something you may not have considered: The massive losses taken by Wall Street banks and brokers are going to wipe out their profit for the next few years. About $500 Billion in write downs have already occurred. Best estimates for the total that will get written down range from $1 trillion to $2 trillion dollars.

That's not only very bad for the firms, their shareholders and employees -- it's also going to be very challenging for the regions where they are headquartered and do much of their business.

In New York State, the 16 largest banks sent taxes totaling $5 million in the most recent reporting period; that compares with $173 million from the same period a year ago.

Taxes paid are down an astonishing 97%!

And it's not just New York. Other money center regions in the US are running into similar problems: California, Connecticut, Virginia, Illinois, and Massachusetts are also likely to have related tax shortfalls. There will be other cities and states beyond these.

Bloomberg reports that:

"Wall Street's mortgage losses have grown so large that some firms may pay little or no taxes for years, widening New York City and state deficits and challenging their ability to provide services," Mayor Michael Bloomberg said.

Some companies are seeking refunds from the city on taxes they paid ahead of time, saying losses have cut their tax liability to zero. The banks pay tax on 110 percent of earnings in advance as a "safe harbor,'' protecting against penalties for underpayment.

"It will be a number of years before Wall Street starts paying taxes again,'' the mayor said at a press conference yesterday in Manhattan. "They will carry forward all of those losses.''

Financial firms posted $501 billion in writedowns and credit losses worldwide since the start of last year, a figure the World Bank predicts may rise to $1 trillion as the credit squeeze sparked by the subprime market collapse worsens. The tax drain is particularly serious in New York, where Wall Street accounts for 20 percent of state revenue and about 9 percent for the city, state Comptroller Thomas DiNapoli has said.  (emphasis added).

It's not just here in the USA that the credit crunch problem is impacting the tax base. Across the pond, the UK is experiencing a similar problem, courtesy of Merrill Lynch's recent write downs of $29 Billion dollars.

The FT notes that "If Merrill’s UK subsidiary were to continue to generate profits at 2006 levels, a record year for the investment banking business, it would pay no UK corporation tax for 60 years."

Merrill Lynch is unlikely to pay corporation tax in the UK for several decades after $29bn (£16bn) of losses suffered by the US investment bank were charged to its London-based subsidiary.

The figures, published in Merrill’s regulatory filings, emphasise how the meltdown in the US subprime mortgage market is undermining tax receipts for governments far beyond America’s borders. They also offer a rare glimpse into the tax management policies of a global financial institution.

The losses arose because almost all of Merrill’s global activity in the market for collateralised debt obligations – complex debt securities, often backed by subprime mortgages – has been channelled through Merrill Lynch International, its UK-based subsidiary.

60 years? Gee, that seems like an awfully long time to go with loss carry forwards. Then again, $30 billion dollars is some real money. But it gives you a sense of exactly how much self inflicted damage the financial sector is suffering.

On the Federal level, we see the continued slow down of personal income tax in the US. This is likely to accelerate as the recession gets deeper and more prolonged, layoffs add up, and income slows:


Chart courtesy of Matt Trivisonno

Consider these corporate and personal tax shortfalls. Then look at a recent congressional study showing that most firms pay no income taxes -- a misleading but incendiary headline -- and you can make the safe bet that whoever gets elected, we will see a new reach for corporate taxes. Watch for various proposals cutting the corporate tax percentage (i.e., 35 to 25 or 30%) but some major loopholes changes.

My forecast: Thanks to the credit crunch, the tax burden on non-financial firms 3 years from now will be appreciably higher than it is today -- regardless of the November 2008 election outcome. And, they are likely to stay that way for quite a while . . .

Financials: Worse than they look? (November 08, 2007)

Wall Street Losses Cut Tax Bill, Sap New York Revenue
Henry Goldman and David Mildenberg
Bloomberg, Aug. 12  2008

Merrill books loss to London unit and avoids UK tax for decades
Peter Thal Larsen in London and Francesco Guerrera in,New York
FT, August 15 2008 03:00

Merrill Books Losses Through U.K., Can Offset Taxes   
Zachary R. Mider and Cathy Chan
Bloomberg, Aug. 15 2008

Most firms pay no income taxes - Congress
David Goldman
CNNMoney.com, August 12, 2008: 4:38 PM EDT