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Bond Weekly: Tax Hike And Proposed Cigarette Tax Cut

Summary

Tax reform plan to be unveiled this week

Unclear as to whether inflation target will be met in 2018

Maintain our view for August that 3-year treasuries will yield 1.62-1.78% and 10-year treasuries 2.1-2.3%.

Tax reform plan to be unveiled this week

The government will unveil a tax-reform plan this week. The aim is to distribute income more equally while easing the tax burdens of the middle class and underprivileged. The reform’s basic direction will be similar to what was agreed at the July 27 meeting with ruling party representatives.
The new administration’s initiatives require vast amounts of money. To fund its policy drives, the government needs to raise tax revenues through tax reform and it may have to issue additional treasury bonds to make up for any shortfall. (The original plan was to raise an additional KRW82.6tn in tax revenue and cut expenditures by KRW95.4tn over the next five years but it remains unclear as to whether the planned expenditure cut is feasible.) Thus, it is important for bond investors to look into the details of the tax-reform measures and understand how they will raise tax revenue.

Unclear as to whether inflation target will be met in 2018

We estimate this year’s inflation at 1.9%, and it will mark the fifth consecutive year which fails to meet the Bank of Korea’s inflation target. Whether the inflation target will be met in 2018 is also uncertain, and the government’s announced plan last week to cut the city gas tariff (by 8-9%, to come into effect in December) has the effect of reducing inflation by 0.15-0.16% (city gas’s weighting 18.3 out of 1000).

Amidst the administration’s proposed changes, last Wednesday the opposing party introduced a bill to slash the cigarette tax and said it was working to lower the oil tax as well. When the country is in dire need of higher tax revenue, the opposing party’s proposal to cut the cigarette tax is unlikely to pass but if it materializes, it would have the effect of reducing inflation 

 0.15-0.16% (city gas’s weighting 18.3 out of 1000).

Amidst the administration’s proposed changes, last Wednesday the opposing party introduced a bill to slash the cigarette tax and said it was working to lower the oil tax as well. When the country is in dire need of higher tax revenue, the opposing party’s proposal to cut the cigarette tax is unlikely to pass but if it materializes, it would have the effect of reducing inflation by 0.476% (assuming the price of a pack of cigarettes comes down to KRW2,500 from KRW4,500; tobacco’s weighting 10.7).

There are expectations that an increased minimum wage will help to boost inflation. However, the relationship between the minimum wage and inflation is controversial and cannot be pinpointed in figures.

Market view

The bond market has remained range-bound for quite some time. The spread remains in the medium range of the box and technical indicators are neutral. In all, the market does not look like it will break out of the box anytime soon.
In terms of supply and demand, the situation appears more favorable. August’s issuance volume has been further reduced and KRW3.5tn worth of buybacks are scheduled. Demand is also firm, thus supply should remain tight.

Over the next one to two months, we will have more opportunities to look into the new administration’s policy. So far, however, we do not see any events that would push the market out of the boxed range. We maintain our view for August that 3-year treasuries will yield 1.62-1.78% and 10-year

treasuries 2.1-2.3%. 

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.