Follow the Money to Real Growth, Not Tax Breaks

This week, David Cay Johnston, former tax reporter for The New York Times, published a stimulating thought experiment titled How Would You Invest $1 Billion Under the Current Tax System? It's premised on the idea that if we use tax policy to boost demand, we can find more profitable ways to invest that proverbial $1 billion.

It's a premise I reject. Based on research for Capital Rising, co-authored with Srini Rangan, I believe that capital will flow toward growth, and growth can be found in emerging markets. In a nutshell, I don't think there is enough tax policy on the planet to fill a thimble compared to the torrent of demand that can be derived from bringing a large country out of the Third World and into the First World.

Johnston, who's now teaching at Syracuse University Law School, reviews the domestic investment horizon and comes to the conclusion that right now, there's no place to invest that offers an attractive return at a reasonable risk. He uses historical statistics to point out the futility of investing in the S&P 500, U.S. utilities, manufacturing, petroleum and coal companies. He then points out the money-losing ways of retailers and the futility of making money buying out-of-favor real estate. What's an investor with that $1 billion burning a hole in his pocket to do?

Johnston's proposed solution is to change the tax structure to boost domestic demand. In my opinion, he is going off the rails with this. First, I don't think people ought to make purchasing decisions just because they can save some money on taxes. When they do, as we saw in the case of the home buyers tax credits that expired this spring, all that is accomplished is to shift future demand into the period before the credit expires. This helps explain June's 27.2% drop in existing home sales.

Send Money Where the Demand Is Real

Simply put, tax policy cannot create demand where it doesn't exist. For real demand, you need an economy that meets real economic needs. Consider Chile. Its economy is growing at 6.5%, and as I wrote in an Aug. 22 article on DailyFinance, the iShares MSCI Chile Investable Market Index Fund (ECH) -- a good proxy for the Chilean stock market -- is up 22.8% so far this year.

What's driving demand in Chile now are the efforts to rebuild from the Feb. 27 earthquake. Bloomberg reports that the quake caused $30 billion in damage, but that Chileans increased consumption following the disaster, and the nation's output is almost back to pre-quake levels. Retail sales spiked 18% in June, 19% in May and 22% in April from the previous year. I don't know how sustainable that growth rate is, but economists expect Chilean GDP to rise 5% in 2010 and 6% to 7% in 2011.

Rather than try to boost domestic demand through tax policy, I would look for countries like Chile that are enjoying rapid economic growth that has not been fully recognized by investors. If Chile's market keeps growing at the 23% it has already spiked in the last year, it would take about 3.5 years to double that $1 billion.

Admittedly, there's no guarantee that's going to happen, but I'd much rather take that chance than wait for Washington to pass enough tax incentives to get the U.S. economy back to growing at 6%.